Praemium (ASX:PPS) Is Growing Earnings But Are They A Good Guide?

As a general rule, we think profitable companies are less risky than companies that lose money. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether Praemium's (ASX:PPS) statutory profits are a good guide to its underlying earnings.

While Praemium was able to generate revenue of AU$50.2m in the last twelve months, we think its profit result of AU$4.86m was more important. One positive is that it has grown both its profit and its revenue, over the last few years.

View our latest analysis for Praemium

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. So today we'll look at what Praemium's cashflow and unusual items tell us about the quality of its earnings, as well as touching on how its recent share issues are impacting shareholders. 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.

Zooming In On Praemium'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. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to June 2020, Praemium recorded an accrual ratio of -0.16. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of AU$6.8m, well over the AU$4.86m it reported in profit. Praemium shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Praemium expanded the number of shares on issue by 23% over the last year. Therefore, each share now receives a smaller portion of profit. 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 Praemium's EPS by clicking here.

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

As you can see above, Praemium has been growing its net income over the last few years, with an annualized gain of 606% over three years. In comparison, earnings per share only gained 585% over the same period. And at a glance the 90% gain in profit over the last year impresses. On the other hand, earnings per share are only up 89% in that time. So you can see that the dilution has had a bit of an impact on shareholders. Therefore, the dilution is having a noteworthy influence on shareholder returns. And so, you can see quite clearly that dilution is influencing shareholder earnings.

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 Praemium can grow EPS persistently. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

How Do Unusual Items Influence Profit?

Praemium's profit was reduced by unusual items worth AU$1.3m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Praemium to produce a higher profit next year, all else being equal.

Our Take On Praemium's Profit Performance

In conclusion, both Praemium's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative, but the dilution means that per-share performance is weaker than the statutory profit numbers imply. Looking at all these factors, we'd say that Praemium's underlying earnings power is at least as good as the statutory numbers would make it seem. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Case in point: We've spotted 1 warning sign for Praemium you should be aware of.

After our examination into the nature of Praemium's profit, we've come away optimistic for the company. 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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