New Stratus Energy's (CVE:NSE) Robust Profit May Be Overstating Its True Earnings Potential

The healthy profit announcement from New Stratus Energy Inc. (CVE:NSE ) didn't seem to impress investors. Our analysis has found some underlying factors which may be cause for concern.

View our latest analysis for New Stratus Energy

A Closer Look At New Stratus Energy's 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. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. 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 March 2022, New Stratus Energy recorded an accrual ratio of 2.72. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of CA$3.0m despite its profit of CA$14.8m, mentioned above. We also note that New Stratus Energy's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CA$3.0m. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.

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

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. In fact, New Stratus Energy increased the number of shares on issue by 29% over the last twelve months by issuing new shares. As a result, its net income is now split between 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 New Stratus Energy's EPS by clicking here.

How Is Dilution Impacting New Stratus Energy's Earnings Per Share (EPS)?

Three years ago, New Stratus Energy lost money. And even focusing only on the last twelve months, we don't have a meaningful growth rate because it made a loss a year ago, too. 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). So you can see that the dilution has had a fairly significant impact on shareholders.

In the long term, if New Stratus Energy's earnings per share can increase, then the share price should too. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. 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.

Our Take On New Stratus Energy's Profit Performance

In conclusion, New Stratus Energy has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). Considering all this we'd argue New Stratus Energy's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about New Stratus Energy as a business, it's important to be aware of any risks it's facing. To help with this, we've discovered 5 warning signs (2 don't sit too well with us!) that you ought to be aware of before buying any shares in New Stratus Energy.

Our examination of New Stratus 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 are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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. 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.