Digital360 S.p.A. (BIT:DIG) recently posted some strong earnings, and the market responded positively. Our analysis found some more factors that we think are good for shareholders.
Examining Cashflow Against Digital360'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. 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. 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 December 2020, Digital360 had an accrual ratio of -0.27. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of €4.6m in the last year, which was a lot more than its statutory profit of €1.07m. Notably, Digital360 had negative free cash flow last year, so the €4.6m it produced this year was a welcome improvement. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.
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. Digital360 expanded the number of shares on issue by 6.7% over the last year. As a result, its net income is now split between a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of Digital360's EPS by clicking here.
How Is Dilution Impacting Digital360's Earnings Per Share? (EPS)
As it happens, we don't know how much the company made or lost three years ago, because we don't have the data. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. So you can see that the dilution has had a bit of an impact on shareholders.
In the long term, if Digital360's earnings per share can increase, then the share price should too. 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 Digital360's Profit Performance
In conclusion, Digital360 has a strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share are dropping faster than its profit. Based on these factors, we think that Digital360's profits are a reasonably conservative guide to its underlying profitability. If you'd like to know more about Digital360 as a business, it's important to be aware of any risks it's facing. For example - Digital360 has 4 warning signs we think you should be aware of.
In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there are plenty of other ways to inform your opinion of a company. 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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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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