We Believe Petratherm's (ASX:PTR) Earnings Are A Poor Guide For Its Profitability

Despite posting strong earnings, Petratherm Limited's (ASX:PTR) stock didn't move much over the last week. We think that investors might be worried about the foundations the earnings are built on.

See our latest analysis for Petratherm

A Closer Look At Petratherm'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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

Petratherm has an accrual ratio of 28.07 for the year to December 2020. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of AU$1.0m, in contrast to the aforementioned profit of AU$18.0m. We also note that Petratherm's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of AU$1.0m. However, that's not the end of the story. 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Petratherm.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. Petratherm expanded the number of shares on issue by 11% over the last year. That means its earnings are split among a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of Petratherm's EPS by clicking here.

How Is Dilution Impacting Petratherm's Earnings Per Share? (EPS)

Petratherm was losing money three years ago. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. But mathematics aside, it is always good to see when a formerly unprofitable business come good (though we accept profit would have been higher if dilution had not been required). Therefore, the dilution is having a noteworthy influence on shareholder returns.

In the long term, if Petratherm's earnings per share can increase, then the share price should too. 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.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Petratherm's profit was boosted by unusual items worth AU$19m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. Petratherm had a rather significant contribution from unusual items relative to its profit to December 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Petratherm's Profit Performance

In conclusion, Petratherm's weak accrual ratio suggested its statutory earnings have been inflated by the unusual items. The dilution means the results are weaker when viewed from a per-share perspective. For all the reasons mentioned above, we think that, at a glance, Petratherm's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. If you'd like to know more about Petratherm as a business, it's important to be aware of any risks it's facing. Our analysis shows 5 warning signs for Petratherm (2 are concerning!) and we strongly recommend you look at these before investing.

Our examination of Petratherm has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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.

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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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