Shareholders Will Be Pleased With The Quality of Daphne International Holdings' (HKG:210) Earnings

Daphne International Holdings Limited (HKG:210) just reported healthy earnings but the stock price didn't move much. Our analysis suggests that investors might be missing some promising details.

See our latest analysis for Daphne International Holdings

A Closer Look At Daphne International Holdings' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

Over the twelve months to December 2023, Daphne International Holdings recorded an accrual ratio of -0.17. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of HK$113m, well over the HK$62.4m it reported in profit. Daphne International Holdings' free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. However, that's not the end of the story. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Daphne International Holdings.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. Daphne International Holdings expanded the number of shares on issue by 9.1% over the last year. That means its earnings are split among a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of Daphne International Holdings' EPS by clicking here.

How Is Dilution Impacting Daphne International Holdings' Earnings Per Share (EPS)?

Three years ago, Daphne International Holdings lost money. On the bright side, in the last twelve months it grew profit by 68%. But EPS was less impressive, up only 65% in that time. And so, you can see quite clearly that dilution is influencing shareholder earnings.

In the long term, earnings per share growth should beget share price growth. So it will certainly be a positive for shareholders if Daphne International Holdings can grow EPS persistently. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

How Do Unusual Items Influence Profit?

Daphne International Holdings' profit was reduced by unusual items worth HK$17m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Daphne International Holdings to produce a higher profit next year, all else being equal.

Our Take On Daphne International Holdings' Profit Performance

Summing up, Daphne International Holdings' accrual ratio and its unusual items suggest that its statutory earnings were temporarily depressed (and could bounce back), while the dilution is a negative for shareholders. Based on these factors, we think Daphne International Holdings' earnings potential is at least as good as it seems, and maybe even better! In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. Case in point: We've spotted 4 warning signs for Daphne International Holdings you should be aware of.

After our examination into the nature of Daphne International Holdings' profit, we've come away optimistic for the company. 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. 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.

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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.