Advance Auto Parts Inc (NYSE:AAP) generated a below-average return on equity of 12.63% in the past 12 months, while its industry returned 13.12%. AAP's results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on AAP’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of AAP's returns. Check out our latest analysis for Advance Auto Parts
What you must know about ROE
Return on Equity (ROE) weighs AAP’s profit against the level of its shareholders’ equity. It essentially shows how much AAP can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for AAP, which is 9.54%. AAP’s ROE exceeds its cost by 3.09%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than AAP’s case of positive discrepancy. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue AAP can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check AAP’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 33.38%, which means AAP still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? Even though AAP returned below the industry average, its ROE comes in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis.
Are you a potential investor? If you are considering investing in AAP, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Advance Auto Parts to help you make a more informed investment decision. If you are not interested in AAP anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.