Industrial Alliance Insurance and Financial Services Inc (TSX:IAG) outperformed the Life and Health Insurance industry on the basis of its ROE – producing a higher 12.05% relative to the peer average of 11.37% over the past 12 months. While the impressive ratio tells us that IAG has made significant profits from little equity capital, ROE doesn’t tell us if IAG has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether IAG’s ROE is actually sustainable. View our latest analysis for Industrial Alliance Insurance and Financial Services

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) is a measure of IAG’s profit relative to its shareholders’ equity. For example, if IAG invests CA$1 in the form of equity, it will generate CA$0.12 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for IAG, which is 8.96%. Since IAG’s return covers its cost in excess of 3.09%, its use of equity capital is efficient and likely to be sustainable. Simply put, IAG pays less for its capital than what it generates in return. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

Dupont Formula

ROE = profit margin × asset turnover × financial leverage

ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)

ROE = annual net profit ÷ shareholders’ equity

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient IAG is with its cost management. Asset turnover reveals how much revenue can be generated from IAG’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable IAG’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine IAG’s debt-to-equity level. At 44.37%, IAG’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.

What this means for you:

Are you a shareholder? IAG’s ROE is impressive relative to the industry average and also covers its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.

Are you a potential investor? If IAG has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Industrial Alliance Insurance and Financial Services to help you make a more informed investment decision.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.