We Wouldn't Rely On Frontier Digital Ventures's (ASX:FDV) Statutory Earnings As A Guide

Broadly speaking, profitable businesses are less risky than unprofitable ones. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. Today we'll focus on whether this year's statutory profits are a good guide to understanding Frontier Digital Ventures (ASX:FDV).

It's good to see that over the last twelve months Frontier Digital Ventures made a profit of AU$6.13m on revenue of AU$16.4m. The chart below shows that revenue has improved over the last three years, and, even better, the company has moved from unprofitable to profitable.

View our latest analysis for Frontier Digital Ventures

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. Therefore, today we'll take a look at Frontier Digital Ventures' cashflow, share issues and unusual items with a view to better understanding the nature of its statutory 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.

Examining Cashflow Against Frontier Digital Ventures' 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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

For the year to June 2020, Frontier Digital Ventures had an accrual ratio of 0.28. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of AU$3.7m, in contrast to the aforementioned profit of AU$6.13m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of AU$3.7m, this year, indicates high risk. 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. The good news for shareholders is that Frontier Digital Ventures' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Frontier Digital Ventures expanded the number of shares on issue by 34% over the last year. Therefore, each share now receives a smaller portion of profit. 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. Check out Frontier Digital Ventures' historical EPS growth by clicking on this link.

How Is Dilution Impacting Frontier Digital Ventures' Earnings Per Share? (EPS)

Frontier Digital Ventures 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). And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

In the long term, if Frontier Digital Ventures' 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.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by AU$13m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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'. Frontier Digital Ventures had a rather significant contribution from unusual items relative to its profit to June 2020. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Frontier Digital Ventures' Profit Performance

Frontier Digital Ventures didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. The dilution means the results are weaker when viewed from a per-share perspective. On reflection, the above-mentioned factors give us the strong impression that Frontier Digital Ventures'underlying earnings power is not as good as it might seem, based on the statutory profit numbers. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Frontier Digital Ventures is showing 4 warning signs in our investment analysis and 2 of those are a bit concerning...

Our examination of Frontier Digital Ventures 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 is always more to discover if you are capable of focussing your mind on minutiae. 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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