The Strong Earnings Posted By Stanmore Resources (ASX:SMR) Are A Good Indication Of The Strength Of The Business

Last week's profit announcement from Stanmore Resources Limited (ASX:SMR) was underwhelming for investors, despite headline numbers being robust. We think that the market might be paying attention to some underlying factors are concerning.

Check out our latest analysis for Stanmore Resources

Zooming In On Stanmore Resources' 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). To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. The ratio shows us how much a company's profit exceeds its FCF.

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".

Stanmore Resources has an accrual ratio of -0.48 for the year to December 2022. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of US$1.1b during the period, dwarfing its reported profit of US$666.8m. Stanmore Resources shareholders are no doubt pleased that free cash flow improved over the last twelve months. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future 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.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. As it happens, Stanmore Resources issued 233% more new shares over the last year. As a result, its net income is now split between a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of Stanmore Resources' EPS by clicking here.

How Is Dilution Impacting Stanmore Resources' Earnings Per Share (EPS)?

We don't have any data on the company's profits from three years ago. On the bright side, in the last twelve months it grew profit by 9,706%. But EPS was less impressive, up only 3,239% in that time. Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Stanmore Resources can grow EPS persistently. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. 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.

Our Take On Stanmore Resources' Profit Performance

At the end of the day, Stanmore Resources is diluting shareholders which will dampen earnings per share growth, but its accrual ratio showed it can back up its profits with free cash flow. Given the contrasting considerations, we don't have a strong view as to whether Stanmore Resources's profits are an apt reflection of its underlying potential for profit. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. You'd be interested to know, that we found 2 warning signs for Stanmore Resources and you'll want to know about these.

Our examination of Stanmore Resources has focussed on certain factors that can make its earnings look better than they are. 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. 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.