Advance Auto Parts (NYSE:AAP) has had a rough three months with its share price down 39%. We decided to study the company's financials to determine if the downtrend will continue as the long-term performance of a company usually dictates market outcomes. In this article, we decided to focus on Advance Auto Parts' ROE.

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. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Advance Auto Parts

How To Calculate Return On Equity?

Return on equity 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:

1.8% = US$47m ÷ US$2.6b (Based on the trailing twelve months to October 2024).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.02.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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. 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 1.8% ROE

As you can see, Advance Auto Parts' ROE looks pretty weak. Not just that, even compared to the industry average of 19%, the company's ROE is entirely unremarkable. Therefore, it might not be wrong to say that the five year net income decline of 26% seen by Advance Auto Parts was possibly a result of it having a lower ROE. However, there could also be other factors causing the earnings to decline. Such as - low earnings retention or poor allocation of capital.

That being said, we compared Advance Auto Parts' performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 17% in the same 5-year period.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about Advance Auto Parts''s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Advance Auto Parts Making Efficient Use Of Its Profits?

Advance Auto Parts has a high three-year median payout ratio of 78% (that is, it is retaining 22% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. Our risks dashboard should have the 3 risks we have identified for Advance Auto Parts.

Moreover, Advance Auto Parts has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 22% over the next three years. The fact that the company's ROE is expected to rise to 9.2% over the same period is explained by the drop in the payout ratio.

Summary

In total, we would have a hard think before deciding on any investment action concerning Advance Auto Parts. Because the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see the lack or absence of growth in its earnings. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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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.