It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. That said, the current statutory profit is not always a good guide to a company’s underlying profitability. In this article, we’ll look at how useful this year’s statutory profit is, when analysing Novo Nordisk (CPH:NOVO B).
While Novo Nordisk was able to generate revenue of kr.126.6b in the last twelve months, we think its profit result of kr.41.4b was more important. Happily, it has grown both its profit and revenue over the last three years, as you can see in the chart below.
Importantly, statutory profits are not always the best tool for understanding a company’s true earnings power, so it’s well worth examining profits in a little more detail. So today we’ll look at what Novo Nordisk’s cashflow tells us about the quality of its earnings. 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.
A Closer Look At Novo Nordisk’s Earnings
One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. 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. 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”.
Over the twelve months to June 2020, Novo Nordisk recorded an accrual ratio of -0.16. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of kr.48b in the last year, which was a lot more than its statutory profit of kr.41.4b. Novo Nordisk’s free cash flow improved over the last year, which is generally good to see.
Our Take On Novo Nordisk’s Profit Performance
Novo Nordisk’s accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Because of this, we think Novo Nordisk’s earnings potential is at least as good as it seems, and maybe even better! And the EPS is up 14% annually, over the last three years. 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. Keep in mind, when it comes to analysing a stock it’s worth noting the risks involved. For example – Novo Nordisk has 1 warning sign we think you should be aware of.
Today we’ve zoomed in on a single data point to better understand the nature of Novo Nordisk’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.
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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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