Here's Why We Don't Think Selvita's (WSE:SLV) Statutory Earnings Reflect Its Underlying Earnings Potential

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. This article will consider whether Selvita's (WSE:SLV) statutory profits are a good guide to its underlying earnings.

We like the fact that Selvita made a profit of zł21.3m on its revenue of zł158.4m, in the last year.

View our latest analysis for Selvita

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. As a result, we'll today take a look at how dilution and cashflow shape our understanding of Selvita's 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.

Examining Cashflow Against Selvita'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). 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. 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, Selvita had an accrual ratio of 0.45. That means it didn't generate anywhere near enough free cash flow to match its profit. As a general rule, that bodes poorly for future profitability. To wit, it produced free cash flow of zł3.5m during the period, falling well short of its reported profit of zł21.3m. At this point we should mention that Selvita did manage to increase its free cash flow in the last twelve months Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. In fact, Selvita increased the number of shares on issue by 15% over the last twelve months by issuing new shares. As a result, its net income is now split between 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. You can see a chart of Selvita's EPS by clicking here.

How Is Dilution Impacting Selvita'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. On the bright side, in the last twelve months it grew profit by 756%. On the other hand, earnings per share are only up 1,439% over the same period. 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.

In the long term, earnings per share growth should beget share price growth. So it will certainly be a positive for shareholders if Selvita can grow EPS persistently. 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 Selvita's Profit Performance

As it turns out, Selvita couldn't match its profit with cashflow and its dilution means that earnings per share growth is lagging net income growth. For the reasons mentioned above, we think that a perfunctory glance at Selvita'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. Every company has risks, and we've spotted 3 warning signs for Selvita (of which 1 can't be ignored!) you should know about.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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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