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Most readers would already be aware that Advance Auto Parts' (NYSE:AAP) stock increased significantly by 15% 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 study its financial indicators more closely to see if they 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 a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How Is ROE Calculated?
The formula for ROE is:
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' is the profit over the last twelve months. That means that for every $1 worth of shareholders' equity, the company generated $0.14 in profit.
What Is The Relationship Between ROE And Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.
Advance Auto Parts' Earnings Growth And 14% ROE
To begin with, Advance Auto Parts seems to have a respectable ROE. Be that as it may, the company's ROE is still quite lower than the industry average of 18%. Additionally, the flat earnings seen by Advance Auto Parts over the past five years doesn't paint a very bright picture. Bear in mind, the company does have a respectable level of ROE. It is just that the industry ROE is higher. Therefore, the flat earnings growth could be the result of other factors. These include low earnings retention or poor capital allocation.
Next, on comparing with the industry net income growth, we found that Advance Auto Parts' reported growth was lower than the industry growth of 7.1% in the same period, which is not something we like to see.
Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. 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 Using Its Retained Earnings Effectively?
Advance Auto Parts' low three-year median payout ratio of 4.0%, (meaning the company retains96% of profits) should mean that the company is retaining most of its earnings and consequently, should see higher growth than it has reported.
Additionally, Advance Auto Parts has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 9.4% over the next three years. However, Advance Auto Parts' future ROE is expected to rise to 22% despite the expected increase in the company's payout ratio. We infer that there could be other factors that could be driving the anticipated growth in the company's ROE.
Overall, we feel that Advance Auto Parts certainly does have some positive factors to consider. Yet, the low earnings growth is a bit concerning, especially given that the company has a respectable rate of return and is reinvesting a huge portion of its profits. By the looks of it, there could be some other factors, not necessarily in control of the business, that's preventing growth. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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.
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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