Legendary Education Group's (HKG:8195) Shareholders Should Assess Earnings With Caution

Even though Legendary Education Group Limited (HKG:8195) posted strong earnings recently, the stock hasn't reacted in a large way. We decided to have a deeper look, and we believe that investors might be worried about several concerning factors that we found.

Check out our latest analysis for Legendary Education Group

Examining Cashflow Against Legendary Education Group'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 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 2024, Legendary Education Group had an accrual ratio of 0.24. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of HK$17m, in contrast to the aforementioned profit of HK$46.2m. We saw that FCF was HK$38m a year ago though, so Legendary Education Group has at least been able to generate positive FCF in the past. Having said that, there is more to consider. 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 Legendary Education Group 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 Legendary Education Group.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. Legendary Education Group expanded the number of shares on issue by 5.6% 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 Legendary Education Group's EPS by clicking here.

A Look At The Impact Of Legendary Education Group's Dilution On Its Earnings Per Share (EPS)

You can see above that Legendary Education Group's profit is about the same as it was three years back. In contrast, its earnings per share is down 21% per year over the same period. The profit growth of 31% in the last twelve months certainly seems very impressive. Then again, EPS was only up 21% over that period. So you can see that the dilution has had a bit of an impact on shareholders.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So Legendary Education 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 the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by HK$4.3m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. If Legendary Education Group doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Legendary Education Group's Profit Performance

Legendary Education Group didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. The dilution means the results are weaker when viewed from a per-share perspective. Considering all this we'd argue Legendary Education Group's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Legendary Education Group, you'd also look into what risks it is currently facing. To help with this, we've discovered 3 warning signs (1 is a bit concerning!) that you ought to be aware of before buying any shares in Legendary Education Group.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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 with significant insider holdings 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.