PSC Insurance Group Limited (ASX:PSI) outperformed the Insurance Brokers industry on the basis of its ROE – producing a higher 27.40% relative to the peer average of 10.88% over the past 12 months. On the surface, this looks fantastic since we know that PSI has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether PSI’s ROE is actually sustainable. View our latest analysis for PSC Insurance Group
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of PSI’s profit relative to its shareholders’ equity. It essentially shows how much PSI can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. PSI’s cost of equity is 8.55%. This means PSI returns enough to cover its own cost of equity, with a buffer of 18.85%. This sustainable practice implies that the company 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue PSI can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check PSI’s historic debt-to-equity ratio. At 56.57%, PSI’s debt-to-equity ratio appears sensible 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? PSI’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of PSI to your portfolio if your personal research is confirming what the ROE is telling you. 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%.