A lackluster earnings announcement from Jumbo Interactive Limited (ASX:JIN) last week didn't sink the stock price. We think that investors are worried about some weaknesses underlying the earnings.
Examining Cashflow Against Jumbo Interactive's 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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.
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".
Jumbo Interactive has an accrual ratio of 0.78 for the year to December 2020. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of AU$14m during the period, falling well short of its reported profit of AU$24.6m. Jumbo Interactive's free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits.
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.
Our Take On Jumbo Interactive's Profit Performance
As we have made quite clear, we're a bit worried that Jumbo Interactive didn't back up the last year's profit with free cashflow. For this reason, we think that Jumbo Interactive's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But on the bright side, its earnings per share have grown at an extremely impressive rate 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. So while earnings quality is important, it's equally important to consider the risks facing Jumbo Interactive at this point in time. Every company has risks, and we've spotted 2 warning signs for Jumbo Interactive (of which 1 is concerning!) you should know about.
This note has only looked at a single factor that sheds light on the nature of Jumbo Interactive's profit. 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. 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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