Here's Why We Think NeoPhotonics's (NYSE:NPTN) Statutory Earnings Might Be Conservative

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether NeoPhotonics's (NYSE:NPTN) statutory profits are a good guide to its underlying earnings.

While NeoPhotonics was able to generate revenue of US$374.8m in the last twelve months, we think its profit result of US$3.32m was more important. The chart below shows that while revenue has fallen over the last three years, the company has moved from unprofitable to profitable.

See our latest analysis for NeoPhotonics

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. Today, we'll discuss NeoPhotonics's free cashflow relative to its earnings, and consider what that tells us about the company. 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 NeoPhotonics's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

NeoPhotonics has an accrual ratio of -0.32 for the year to March 2020. 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 US$42m, well over the US$3.32m it reported in profit. NeoPhotonics's free cash flow improved over the last year, which is generally good to see.

Our Take On NeoPhotonics's Profit Performance

Happily for shareholders, NeoPhotonics produced plenty of free cash flow to back up its statutory profit numbers. Because of this, we think NeoPhotonics's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And it's also positive that the company showed enough improvement to book a profit this year, after losing money last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. If you want to do dive deeper into NeoPhotonics, you'd also look into what risks it is currently facing. In terms of investment risks, we've identified 2 warning signs with NeoPhotonics, and understanding these should be part of your investment process.

Today we've zoomed in on a single data point to better understand the nature of NeoPhotonics's profit. But there are plenty of other ways to inform your opinion of a company. 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. 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.
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