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In this article, let´s see one of the most important financial ratios applying to stockholders, the best measure of performance for a firm's management: the Return on Equity (ROE), and we are going to analyze it in the case of Advance Auto Parts Inc. (NYSE:AAP).

ROE is calculated as net income applicable to common shares divided by the average book value of common equity: ROE = Net Income / Av. Book Value

A higher ROE is viewed as a positive aspect for the company, but the reason behind it should be examine. From the equation above, we can see that if book value is decreasing more rapidly than net income, the ratio will increase, but this is not good for the firm.

Dupont Analysis

This approach can be used to analyze the ROE. With some algebra we can break down ROE into a function of different ratios. Firstly, we are going to consider the original approach:

Original DuPont equation: Three-Part DuPont

Taking the ROE equation: ROE = net income / shareholder's equity and multiplying ROE by (revenue / revenue), and rearranging terms we get:

ROE = (net income / revenue) * (revenue / shareholder's equity)

We now have ROE broken into two parts, the first is net profit margin, and the second is the equity turnover ratio.Nowwe can expand this by multiplying these terms by (assets / assets), and rearranging we end up with the three-step DuPont equation.

ROE = (Net Income / Revenue) * (Revenue / Assets) * (Assets / Shareholder's Equity)

This equation for ROE breaks it into three widely used and studied components:

ROE = (Net profit margin)* (Asset Turnover) * (Leverage ratio)

The first term is what we called previously net profit margin, the second term is asset turnover and the third tem is a financial leverage ratio. If we have a low ROE, one of the following must be true:

• The firm has a poor profit margin
• The firm has a poor asset turnover
• The firm has a little leverage
 ROE (%) 3-Step Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Net Profit Margin 4.99 5.50 5.01 4.92 4.63 5.00 5.84 6.40 6.25 6.03 Asset Turnover 1.71 1.68 1.72 1.73 1.74 1.76 1.77 1.69 1.35 1.17 Leverage 3.03 2.78 2.63 2.70 2.78 2.38 3.23 4.35 3.85 3.70 ROE 26.03 25.52 22.44 23.28 22.14 21.08 33.29 46.55 32.02 25.84

Final Comment

As outlined in the article, a key ratio used to determine management efficiency is the ROE. In general, analysts consider ROE ratios in the 15-20% range as representing attractive levels for investment. As we can appreciate, the ROE was higher in all of the years, principally due to its high net profit margin.

It is very important to understand this metric before investing and it is important to look at the trend in ROE over time. So let´s see the evolution on the next chart:

So based on this analysis, I would recommend investors to consider adding this stock to their long-term portfolios.

Hedge fund gurus have also been active in the company. Gurus like Kyle Bass (Trades, Portfolio), Jim Simons (Trades, Portfolio), Chuck Royce (Trades, Portfolio) and Charles Brandes (Trades, Portfolio) added the stock in the second quarter of 2014.

Disclosure: Omar Venerio holds no position in any stocks mentioned.

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ovenerio
Omar Venerio is capital markets, derivatives, corporate finance and financial management professor. He is passionate about the stock market and providing independent fundamental research and hedge fund and insider trading-focused investigation.

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