Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it’s not always clear whether statutory profits are a good guide, going forward. This article will consider whether Magellan Health‘s (NASDAQ:MGLN) statutory profits are a good guide to its underlying earnings.
It’s good to see that over the last twelve months Magellan Health made a profit of US$7.35m on revenue of US$7.20b. The chart below shows how it has grown revenue over the last three years, but that profit has declined.
Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. As a result, we think it’s well worth considering what Magellan Health’s cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. 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.
Zooming In On Magellan Health’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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. The ratio shows us how much a company’s profit exceeds its FCF.
Therefore, it’s actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. That is not intended to imply we should worry about a positive accrual ratio, but it’s worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.
Magellan Health has an accrual ratio of -0.11 for the year to September 2019. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. To wit, it produced free cash flow of US$214m during the period, dwarfing its reported profit of US$7.35m. Magellan Health shareholders are no doubt pleased that free cash flow improved over the last twelve months.
Our Take On Magellan Health’s Profit Performance
As we discussed above, Magellan Health has perfectly satisfactory free cash flow relative to profit. Because of this, we think Magellan Health’s earnings potential is at least as good as it seems, and maybe even better! On the other hand, its EPS actually shrunk in the last twelve months. At the end of the day, it’s essential to consider more than just the factors above, if you want to understand the company properly. Obviously, we love to consider the historical data to inform our opinion of a company. But it can be really valuable to consider what other analysts are forecasting. So feel free to check out our free graph representing analyst forecasts.
This note has only looked at a single factor that sheds light on the nature of Magellan Health’s profit. But there is always more to discover if you are capable of focussing your mind on minutiae. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to ‘follow the money’ and search out stocks that insiders are buying. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.
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.
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