Investors Can Find Comfort In REA Group's (ASX:REA) Earnings Quality

REA Group Limited's (ASX:REA) recent soft profit numbers didn't appear to worry shareholders, as the stock price showed strength. However, we think the company is showing some signs that things are more promising than they seem.

View our latest analysis for REA Group

Zooming In On REA Group'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. The ratio shows us how much a company's profit exceeds its FCF.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to June 2024, REA Group had an accrual ratio of -0.10. That indicates that its free cash flow was a fair bit more than its statutory profit. In fact, it had free cash flow of AU$464m in the last year, which was a lot more than its statutory profit of AU$302.8m. REA Group's free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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.

The Impact Of Unusual Items On Profit

REA Group's profit was reduced by unusual items worth AU$155m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect REA Group to produce a higher profit next year, all else being equal.

Our Take On REA Group's Profit Performance

In conclusion, both REA Group's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think REA Group's earnings potential is at least as good as it seems, and maybe even better! If you want to do dive deeper into REA Group, you'd also look into what risks it is currently facing. At Simply Wall St, we found 1 warning sign for REA Group and we think they deserve your attention.

Our examination of REA Group has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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 with high insider ownership.

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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.