We Think Modern Times Group MTG's (STO:MTG B) Healthy Earnings Might Be Conservative

Shareholders appeared to be happy with Modern Times Group MTG AB (publ)'s (STO:MTG B) solid earnings report last week. This reaction by the market reaction is understandable when looking at headline profits and we have found some further encouraging factors.

Our analysis indicates that MTG B is potentially overvalued!

Zooming In On Modern Times Group MTG's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. The ratio shows us how much a company's profit exceeds its FCF.

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".

Over the twelve months to September 2022, Modern Times Group MTG recorded an accrual ratio of -0.82. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of kr9.3b in the last year, which was a lot more than its statutory profit of kr175.0m. Given that Modern Times Group MTG had negative free cash flow in the prior corresponding period, the trailing twelve month resul of kr9.3b would seem to be a step in the right direction. However, that's not the end of the story. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively.

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.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Modern Times Group MTG expanded the number of shares on issue by 13% over the last year. 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. Check out Modern Times Group MTG's historical EPS growth by clicking on this link.

How Is Dilution Impacting Modern Times Group MTG's Earnings Per Share (EPS)?

Three years ago, Modern Times Group MTG lost money. On the bright side, in the last twelve months it grew profit by 51%. On the other hand, earnings per share are only up 24% over the same period. 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 Modern Times Group MTG 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.

The Impact Of Unusual Items On Profit

Modern Times Group MTG's profit was reduced by unusual items worth kr40m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect Modern Times Group MTG to produce a higher profit next year, all else being equal.

Our Take On Modern Times Group MTG's Profit Performance

In conclusion, both Modern Times Group MTG's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative, but the dilution means that per-share performance is weaker than the statutory profit numbers imply. Looking at all these factors, we'd say that Modern Times Group MTG's underlying earnings power is at least as good as the statutory numbers would make it seem. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. In terms of investment risks, we've identified 1 warning sign with Modern Times Group MTG, and understanding it should be part of your investment process.

Our examination of Modern Times Group MTG has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.