Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. In this article, we’ll look at how useful this year’s statutory profit is, when analysing CASwell (TPE:6416).
We like the fact that CASwell made a profit of NT$312.7m on its revenue of NT$4.22b, in the last year. The chart below shows how it has grown revenue over the last three years, but that profit has declined.
Not all profits are equal, and we can learn more about the nature of a company’s past profitability by diving deeper into the financial statements. So today we’ll look at what CASwell’s cashflow tells us about its earnings, as well as examining how issuing shares is impacting shareholder value. That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.
Examining Cashflow Against CASwell’s Earnings
Many investors haven’t heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company’s profit is backed up by free cash flow (FCF) during a given period. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company’s average operating assets over that period. You could think of the accrual ratio from cashflow as the ‘non-FCF profit ratio’.
That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. While it’s not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.
For the year to September 2019, CASwell had an accrual ratio of 0.25. Therefore, we know that it’s free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of NT$312.7m, a look at free cash flow indicates it actually burnt through NT$106m in the last year. We saw that FCF was NT$529m a year ago though, so CASwell has at least been able to generate positive FCF in the past. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings. The good news for shareholders is that CASwell’s accrual ratio was much better last year, so this year’s poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.
One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, CASwell issued 5.8% more new shares over the last year. That means its earnings are split among a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of CASwell’s EPS by clicking here.
A Look At The Impact Of CASwell’s Dilution on Its Earnings Per Share (EPS).
CASwell’s net profit dropped by 27% per year over the last three years. And even focusing only on the last twelve months, we see profit is down 10%. Like a sack of potatoes thrown from a delivery truck, EPS fell harder, down 15% in the same period. So you can see that the dilution has had a bit of an impact on shareholders. Therefore, the dilution is having a noteworthy influence on shareholder returns. And so, you can see quite clearly that dilution is influencing shareholder earnings.
In the long term, if CASwell’s earnings per share can increase, then the share price should too. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical “share” of the company’s profit.
Our Take On CASwell’s Profit Performance
In conclusion, CASwell has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). For the reasons mentioned above, we think that a perfunctory glance at CASwell’s statutory profits might make it look better than it really is on an underlying level. So if you’d like to dive deeper into this stock, it’s crucial to consider any risks it’s facing. When we did our research, we found 2 warning signs for CASwell (1 is potentially serious!) that we believe deserve your full attention.
In this article we’ve looked at a number of factors that can impair the utility of profit numbers, and we’ve come away cautious. But there is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying to be useful.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.
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