Shaky Earnings May Not Tell The Whole Story For Central China Real Estate (HKG:832)

Central China Real Estate Limited (HKG:832) recently posted soft earnings but shareholders didn't react strongly. We did some digging, and we believe that investors are missing some worrying factors underlying the profit figures.

See our latest analysis for Central China Real Estate

A Closer Look At Central China Real Estate's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Central China Real Estate has an accrual ratio of 0.23 for the year to June 2021. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of CN¥1.80b, a look at free cash flow indicates it actually burnt through CN¥3.6b in the last year. We saw that FCF was CN¥3.5b a year ago though, so Central China Real Estate has at least been able to generate positive FCF in the past. Having said that, there is more to consider. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively. The good news for shareholders is that Central China Real Estate's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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, Central China Real Estate issued 5.7% more new shares over the last year. That means its earnings are split among 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. Check out Central China Real Estate's historical EPS growth by clicking on this link.

A Look At The Impact Of Central China Real Estate's Dilution on Its Earnings Per Share (EPS).

As you can see above, Central China Real Estate has been growing its net income over the last few years, with an annualized gain of 88% over three years. In comparison, earnings per share only gained 64% over the same period. Net income was down 13% over the last twelve months. But the EPS result was even worth, with the company recording a decline of 16%. And so, you can see quite clearly that dilution is influencing shareholder earnings.

In the long term, if Central China Real Estate'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 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

Given the accrual ratio, it's not overly surprising that Central China Real Estate's profit was boosted by unusual items worth CN¥844m in the last twelve months. 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 Central China Real Estate 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 Central China Real Estate's Profit Performance

Central China Real Estate 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. For the reasons mentioned above, we think that a perfunctory glance at Central China Real Estate's statutory profits might make it look better than it really is on an underlying level. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Central China Real Estate is showing 5 warning signs in our investment analysis and 2 of those are a bit concerning...

Our examination of Central China Real Estate 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. 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 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.
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