Advance Auto Parts, Inc. (NYSE:AAP) Stock's On A Decline: Are Poor Fundamentals The Cause?

Advance Auto Parts (NYSE:AAP) has had a rough three months with its share price down 19%. Given that stock prices are usually driven by a company’s fundamentals over the long term, which in this case look pretty weak, we decided to study the company's key financial indicators. Particularly, we will be paying attention to Advance Auto Parts' ROE today.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Advance Auto Parts

How To Calculate Return On Equity?

Return on equity can be calculated by using the formula:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Advance Auto Parts is:

0.8% = US$21m ÷ US$2.6b (Based on the trailing twelve months to April 2024).

The 'return' is the income the business earned over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.01.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Advance Auto Parts' Earnings Growth And 0.8% ROE

It is hard to argue that Advance Auto Parts' ROE is much good in and of itself. Even when compared to the industry average of 19%, the ROE figure is pretty disappointing. For this reason, Advance Auto Parts' five year net income decline of 13% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.

That being said, we compared Advance Auto Parts' performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 23% in the same 5-year period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. Has the market priced in the future outlook for AAP? You can find out in our latest intrinsic value infographic research report.

Is Advance Auto Parts Making Efficient Use Of Its Profits?

Advance Auto Parts' declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 72% (or a retention ratio of 28%). With only very little left to reinvest into the business, growth in earnings is far from likely. Our risks dashboard should have the 3 risks we have identified for Advance Auto Parts.

In addition, Advance Auto Parts has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 19% over the next three years. The fact that the company's ROE is expected to rise to 9.2% over the same period is explained by the drop in the payout ratio.

Summary

In total, we would have a hard think before deciding on any investment action concerning Advance Auto Parts. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com