Advance Auto Parts, Inc.'s (NYSE:AAP) Stock Has Shown A Decent Performance: Have Financials A Role To Play?

Advance Auto Parts' (NYSE:AAP) stock is up by 5.7% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to investigate if the company's decent financials had a hand to play in the recent price move. Specifically, we decided to study Advance Auto Parts' ROE in this article.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

View our latest analysis for Advance Auto Parts

How Is ROE Calculated?

The formula for return on equity is:

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

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

13% = US$477m ÷ US$3.8b (Based on the trailing twelve months to October 2020).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.13 in profit.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

A Side By Side comparison of Advance Auto Parts' Earnings Growth And 13% ROE

To begin with, Advance Auto Parts seems to have a respectable ROE. Even so, when compared with the average industry ROE of 17%, we aren't very excited. Further, Advance Auto Parts' five year net income growth of -0.5% is more or less flat. Not to forget, the company does have a decent ROE to begin with, just that it is lower than the industry average. Therefore, the flat earnings growth could be the result of other factors. For example, it could be that the company has a high payout ratio or the business has alloacted capital, for instance.

As a next step, we compared Advance Auto Parts' net income growth with the industry and discovered that the industry saw an average growth of 7.1% in the same period.

Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. Is AAP fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Advance Auto Parts Using Its Retained Earnings Effectively?

Advance Auto Parts has a low three-year median payout ratio of 4.0% (or a retention ratio of 96%) but the negligible earnings growth number doesn't reflect this as high growth usually follows high profit retention.

Moreover, Advance Auto Parts has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 19% over the next three years. Still, forecasts suggest that Advance Auto Parts' future ROE will rise to 26% even though the the company's payout ratio is expected to rise. We presume that there could some other characteristics of the business that could be driving the anticipated growth in the company's ROE.

Summary

In total, it does look like Advance Auto Parts has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a moderate ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. 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 company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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This article by Simply Wall St is general in nature. 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.
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