It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. This article will consider whether ES Ceramics Technology Berhad's (KLSE:ESCERAM) statutory profits are a good guide to its underlying earnings.
We like the fact that ES Ceramics Technology Berhad made a profit of RM7.45m on its revenue of RM45.1m, in the last year.
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. So today we'll look at what ES Ceramics Technology Berhad's cashflow tells us about its earnings, as well as examining how issuing shares is impacting shareholder value. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of ES Ceramics Technology Berhad.
A Closer Look At ES Ceramics Technology Berhad'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). The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.
For the year to November 2020, ES Ceramics Technology Berhad had an accrual ratio of -0.50. 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 RM20m during the period, dwarfing its reported profit of RM7.45m. ES Ceramics Technology Berhad shareholders are no doubt pleased that free cash flow improved over the last twelve months. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.
To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. ES Ceramics Technology Berhad expanded the number of shares on issue by 12% 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 ES Ceramics Technology Berhad's EPS by clicking here.
A Look At The Impact Of ES Ceramics Technology Berhad's Dilution on Its Earnings Per Share (EPS).
Unfortunately, we don't have any visibility into its profits three years back, because we lack the data. On the bright side, in the last twelve months it grew profit by 217%. But EPS was less impressive, up only 168% in that time. So you can see that the dilution has had a bit of an impact on shareholders. Therefore, the dilution is having a noteworthy influence on shareholder returns. And so, you can see quite clearly that dilution is influencing shareholder earnings.
Changes in the share price do tend to reflect changes in earnings per share, in the long run. So ES Ceramics Technology Berhad shareholders will want to see that EPS figure continue to increase. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. 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 ES Ceramics Technology Berhad's Profit Performance
At the end of the day, ES Ceramics Technology Berhad is diluting shareholders which will dampen earnings per share growth, but its accrual ratio showed it can back up its profits with free cash flow. Based on these factors, we think that ES Ceramics Technology Berhad's profits are a reasonably conservative guide to its underlying profitability. So while earnings quality is important, it's equally important to consider the risks facing ES Ceramics Technology Berhad at this point in time. To help with this, we've discovered 4 warning signs (1 makes us a bit uncomfortable!) that you ought to be aware of before buying any shares in ES Ceramics Technology Berhad.
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 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 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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