Did you know there are some financial metrics that can provide clues of a potential multi-bagger? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. In light of that, when we looked at Advance Auto Parts (NYSE:AAP) and its ROCE trend, we weren't exactly thrilled.
What is Return On Capital Employed (ROCE)?
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. To calculate this metric for Advance Auto Parts, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.14 = US$975m ÷ (US$12b - US$4.9b) (Based on the trailing twelve months to July 2021).
So, Advance Auto Parts has an ROCE of 14%. In absolute terms, that's a pretty standard return but compared to the Specialty Retail industry average it falls behind.
Above you can see how the current ROCE for Advance Auto Parts compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Advance Auto Parts here for free.
So How Is Advance Auto Parts' ROCE Trending?
When we looked at the ROCE trend at Advance Auto Parts, we didn't gain much confidence. Around five years ago the returns on capital were 20%, but since then they've fallen to 14%. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.
On a side note, Advance Auto Parts' current liabilities are still rather high at 41% of total assets. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.
The Key Takeaway
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Advance Auto Parts. And the stock has followed suit returning a meaningful 48% to shareholders over the last five years. So should these growth trends continue, we'd be optimistic on the stock going forward.
Advance Auto Parts does have some risks though, and we've spotted 1 warning sign for Advance Auto Parts that you might be interested in.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
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.
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