Advance Auto Parts, Inc.'s (NYSE:AAP) Stock On An Uptrend: Could Fundamentals Be Driving The Momentum?

Most readers would already be aware that Advance Auto Parts' (NYSE:AAP) stock increased significantly by 31% over the past three months. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. 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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Advance Auto Parts

How To Calculate Return On Equity?

ROE 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:

14% = US$493m ÷ US$3.6b (Based on the trailing twelve months to January 2021).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.14 in profit.

What Is The Relationship Between ROE And 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. 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 14% ROE

At first glance, Advance Auto Parts seems to have a decent ROE. Be that as it may, the company's ROE is still quite lower than the industry average of 21%. On further research, we found that Advance Auto Parts' earnings over the past five years have been pretty flat. Bear in mind, the company does have a respectable level of ROE. It is just that the industry ROE is higher. So there might be other reasons for the flat earnings growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitve pressures.

As a next step, we compared Advance Auto Parts' net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 12% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. 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 Efficiently Re-investing Its Profits?

Advance Auto Parts' low three-year median payout ratio of 4.0% (implying that the company keeps96% of its income) should mean that the company is retaining most of its earnings to fuel its growth and this should be reflected in its growth number, but that's not the case.

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. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 28% over the next three years. Regardless, the future ROE for Advance Auto Parts is speculated to rise to 23% despite the anticipated increase in the payout ratio. There could probably be other factors that could be driving the future growth in the ROE.

Conclusion

Overall, we feel that Advance Auto Parts certainly does have some positive factors to consider. 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. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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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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