We Think Wavestone's (EPA:WAVE) Statutory Profit Might Understate Its Earnings Potential

Broadly speaking, profitable businesses are less risky than unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. Today we'll focus on whether this year's statutory profits are a good guide to understanding Wavestone (EPA:WAVE).

We like the fact that Wavestone made a profit of €28.8m on its revenue of €414.4m, in the last year. Happily, it has grown both its profit and revenue over the last three years (though we note its profit is down over the last year).

Check out our latest analysis for Wavestone

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. As a result, today we're going to take a closer look at Wavestone's cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. 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 Wavestone'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. 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. 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".

For the year to September 2020, Wavestone had an accrual ratio of -0.15. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of €60m during the period, dwarfing its reported profit of €28.8m. Wavestone shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

How Do Unusual Items Influence Profit?

Wavestone's profit was reduced by unusual items worth €11m 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. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. If Wavestone doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Wavestone's Profit Performance

In conclusion, both Wavestone's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Looking at all these factors, we'd say that Wavestone's underlying earnings power is at least as good as the statutory numbers would make it seem. So while earnings quality is important, it's equally important to consider the risks facing Wavestone at this point in time. In terms of investment risks, we've identified 1 warning sign with Wavestone, and understanding it should be part of your investment process.

Our examination of Wavestone has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there is always more to discover if you are capable of focussing your mind on minutiae. 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. 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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