Why Road Environment TechnologyLtd's (SHSE:688156) Earnings Are Weaker Than They Seem

After announcing healthy earnings, Road Environment Technology Co.,Ltd.'s (SHSE:688156) stock rose over the last week. Despite the strong profit numbers, we believe that there are some deeper issues which investors should look into.

See our latest analysis for Road Environment TechnologyLtd

Zooming In On Road Environment TechnologyLtd'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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

For the year to March 2024, Road Environment TechnologyLtd had an accrual ratio of 0.48. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of CN¥29.0m, a look at free cash flow indicates it actually burnt through CN¥388m in the last year. We also note that Road Environment TechnologyLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥388m. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future 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.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. As it happens, Road Environment TechnologyLtd issued 9.0% more new shares over the last year. That means its earnings are split among a greater number of shares. 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. You can see a chart of Road Environment TechnologyLtd's EPS by clicking here.

How Is Dilution Impacting Road Environment TechnologyLtd's Earnings Per Share (EPS)?

Road Environment TechnologyLtd's net profit dropped by 56% per year over the last three years. On the bright side, in the last twelve months it grew profit by 12%. On the other hand, earnings per share are only up 6.2% over the same period. Therefore, the dilution is having a noteworthy influence on shareholder returns.

In the long term, earnings per share growth should beget share price growth. So it will certainly be a positive for shareholders if Road Environment TechnologyLtd can grow EPS persistently. 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.

Our Take On Road Environment TechnologyLtd's Profit Performance

In conclusion, Road Environment TechnologyLtd has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means its earnings per share growth is weaker than its profit growth. Considering all this we'd argue Road Environment TechnologyLtd's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Road Environment TechnologyLtd, you'd also look into what risks it is currently facing. Every company has risks, and we've spotted 2 warning signs for Road Environment TechnologyLtd (of which 1 is a bit concerning!) you should know about.

Our examination of Road Environment TechnologyLtd 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. 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.