Statistically speaking, it is less risky to invest in profitable companies than in 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 PGO's (WSE:PGO) statutory profits are a good guide to its underlying earnings.
While PGO was able to generate revenue of zł332.7m in the last twelve months, we think its profit result of zł16.3m was more important. In the chart below, you can see that its profit and revenue have both grown over the last three years, although its revenue has slipped in the last twelve months.
Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. Today, we'll discuss PGO's free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of PGO.
Zooming In On PGO'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".
PGO has an accrual ratio of -0.11 for the year to June 2020. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of zł54m, well over the zł16.3m it reported in profit. Given that PGO had negative free cash flow in the prior corresponding period, the trailing twelve month resul of zł54m would seem to be a step in the right direction.
Our Take On PGO's Profit Performance
As we discussed above, PGO has perfectly satisfactory free cash flow relative to profit. Based on this observation, we consider it likely that PGO's statutory profit actually understates its earnings potential! And on top of that, its earnings per share have grown at 17% per year over the last three years. 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. So while earnings quality is important, it's equally important to consider the risks facing PGO at this point in time. Our analysis shows 2 warning signs for PGO (1 doesn't sit too well with us!) and we strongly recommend you look at these before investing.
Today we've zoomed in on a single data point to better understand the nature of PGO's profit. 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. 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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