Today we’ll look at Advance Auto Parts, Inc. (NYSE:AAP) and reflect on its potential as an investment. To be precise, we’ll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
First, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. And finally, we’ll look at how its current liabilities are impacting its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. Generally speaking a higher ROCE is better. Ultimately, it is a useful but imperfect metric. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.’
So, How Do We Calculate ROCE?
Analysts use this formula to calculate return on capital employed:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
Or for Advance Auto Parts:
0.14 = US$712m ÷ (US$9.0b – US$3.9b) (Based on the trailing twelve months to December 2018.)
So, Advance Auto Parts has an ROCE of 14%.
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Does Advance Auto Parts Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. It appears that Advance Auto Parts’s ROCE is fairly close to the Specialty Retail industry average of 13%. Independently of how Advance Auto Parts compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
Advance Auto Parts’s current ROCE of 14% is lower than its ROCE in the past, which was 19%, 3 years ago. This makes us wonder if the business is facing new challenges.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
How Advance Auto Parts’s Current Liabilities Impact Its ROCE
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.
Advance Auto Parts has total assets of US$9.0b and current liabilities of US$3.9b. Therefore its current liabilities are equivalent to approximately 43% of its total assets. Advance Auto Parts has a middling amount of current liabilities, increasing its ROCE somewhat.
The Bottom Line On Advance Auto Parts’s ROCE
While its ROCE looks good, it’s worth remembering that the current liabilities are making the business look better. You might be able to find a better buy than Advance Auto Parts. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
I will like Advance Auto Parts better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.