Here's Why We Don't Think Instone Real Estate Group's (ETR:INS) Statutory Earnings Reflect Its Underlying Earnings Potential

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. That said, the current statutory profit is not always a good guide to a company's underlying profitability. In this article, we'll look at how useful this year's statutory profit is, when analysing Instone Real Estate Group (ETR:INS).

We like the fact that Instone Real Estate Group made a profit of €57.1m on its revenue of €489.0m, in the last year. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.

Check out our latest analysis for Instone Real Estate Group

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. So today we'll look at what Instone Real Estate Group's cashflow tells us about its earnings, as well as examining how issuing shares is impacting shareholder value. 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.

A Closer Look At Instone Real Estate Group's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Instone Real Estate Group has an accrual ratio of 0.27 for the year to September 2020. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of €57.1m, a look at free cash flow indicates it actually burnt through €147m in the last year. We also note that Instone Real Estate Group's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of €147m. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Instone Real Estate Group issued 27% more new shares over the last year. Therefore, each share now receives a smaller portion of profit. 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 Instone Real Estate Group's EPS by clicking here.

How Is Dilution Impacting Instone Real Estate Group's Earnings Per Share? (EPS)

Instone Real Estate Group was losing money three years ago. On the bright side, in the last twelve months it grew profit by 11%. But EPS was less impressive, up only 30% in that time. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So Instone Real Estate Group shareholders will want to see that EPS figure continue to increase. 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 Instone Real Estate Group's Profit Performance

As it turns out, Instone Real Estate Group couldn't match its profit with cashflow and its dilution means that earnings per share growth is lagging net income growth. For the reasons mentioned above, we think that a perfunctory glance at Instone Real Estate Group's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Instone Real Estate Group, you'd also look into what risks it is currently facing. Every company has risks, and we've spotted 3 warning signs for Instone Real Estate Group (of which 2 are concerning!) you should know about.

Our examination of Instone Real Estate Group 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. 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. 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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