Broadly speaking, profitable businesses are less risky than 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. In this article, we’ll look at how useful this year’s statutory profit is, when analysing Premier Oil (LON:PMO).
While Premier Oil was able to generate revenue of US$1.64b in the last twelve months, we think its profit result of US$127.4m was more important. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.
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 this article aims to better understand Premier Oil’s underlying earnings power by taking a look at how dilution, and unusual items are impacting it, and considering how well those paper profits are being converted into cash flow. 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 Premier Oil’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. This ratio tells us how much of a company’s profit is not backed by free cashflow.
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”.
For the year to June 2019, Premier Oil had an accrual ratio of -0.21. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of US$824m in the last year, which was a lot more than its statutory profit of US$127.4m. Premier Oil’s free cash flow improved over the last year, which is generally good to see.
Having said that, there is more to consider. 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. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.
One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Premier Oil issued 29% more new shares over the last year. That means its earnings are split among a greater number of shares. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. Check out Premier Oil’s historical EPS growth by clicking on this link.
How Is Dilution Impacting Premier Oil’s Earnings Per Share? (EPS)
Three years ago, Premier Oil lost money. Zooming in to the last year, we still can’t talk about growth rates coherently, since it made a loss last year. What we do know is that while it’s great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn’t needed to issue shares. So you can see that the dilution has had a fairly significant impact on shareholders.
If Premier Oil’s EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. 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?
While the accrual ratio might bode well, we also note that Premier Oil’s profit was boosted by unusual items worth US$50m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it’s very common for unusual items to be once-off in nature. Which is hardly suprising, given the name. Assuming those unusual items don’t show up again in the current year, we’d thus expect profit to be weaker next year (in the absence of business growth, that is).
Our Take On Premier Oil’s Profit Performance
In conclusion, Premier Oil’s accrual ratio suggests its earnings are well backed by cash but its boost from unusual items is probably not going to be repeated consistently. Further, the dilution means profits are now split more ways. Having considered these factors, we don’t think Premier Oil’s statutory profits give an overly harsh view of the business. 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.
In this article we’ve looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there are plenty of other ways to inform your opinion of a company. 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.
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