Stock Analysis

We Wouldn't Rely On Pentamaster International's (HKG:1665) Statutory Earnings As A Guide

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SEHK:1665
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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. This article will consider whether Pentamaster International's (HKG:1665) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Pentamaster International made a profit of RM115.1m on revenue of RM433.9m. One positive is that it has grown both its profit and its revenue, over the last few years, though not in the last twelve months.

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earnings-and-revenue-history
SEHK:1665 Earnings and Revenue History December 7th 2020

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. As a result, we think it's well worth considering what Pentamaster International's cashflow (when compared to its earnings) can tell us about the nature of 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 Pentamaster International's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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'.

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. 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 September 2020, Pentamaster International had an accrual ratio of 0.71. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. Indeed, in the last twelve months it reported free cash flow of RM4.9m, which is significantly less than its profit of RM115.1m. Pentamaster International shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months.

Our Take On Pentamaster International's Profit Performance

As we discussed above, we think Pentamaster International's earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that Pentamaster International's underlying earnings power is lower than its statutory profit. But the good news is that its EPS growth over the last three years has been very impressive. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. If you'd like to know more about Pentamaster International as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 2 warning signs for Pentamaster International (of which 1 doesn't sit too well with us!) you should know about.

This note has only looked at a single factor that sheds light on the nature of Pentamaster International's profit. 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. 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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