Following the release of a positive earnings report recently, Perpetual Energy Inc.'s (TSE:PMT) stock performed well. Investors should be cautious however, as there some causes of concern deeper in the numbers.
A Closer Look At Perpetual Energy'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. This ratio tells us how much of a company's profit is not backed by free cashflow.
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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.
Over the twelve months to June 2021, Perpetual Energy recorded an accrual ratio of 0.35. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Even though it reported a profit of CA$31.3m, a look at free cash flow indicates it actually burnt through CA$2.1m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CA$2.1m, this year, indicates high risk. 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 positive for Perpetual Energy shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Perpetual Energy.
One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Perpetual Energy issued 5.2% more new shares over the last year. That means its earnings are split among a greater number of shares. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. You can see a chart of Perpetual Energy's EPS by clicking here.
A Look At The Impact Of Perpetual Energy's Dilution on Its Earnings Per Share (EPS).
Three years ago, Perpetual Energy lost money. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. Therefore, the dilution is having a noteworthy influence on shareholder returns.
In the long term, if Perpetual Energy'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 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?
The fact that the company had unusual items boosting profit by CA$82m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Perpetual Energy had a rather significant contribution from unusual items relative to its profit to June 2021. 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 Perpetual Energy's Profit Performance
In conclusion, Perpetual Energy'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. On reflection, the above-mentioned factors give us the strong impression that Perpetual Energy'sunderlying 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. Case in point: We've spotted 5 warning signs for Perpetual Energy you should be mindful of and 2 of them are potentially serious.
Our examination of Perpetual Energy 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. 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. 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.
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