Are Kung Sing Engineering's (TPE:5521) Statutory Earnings A Good Reflection Of Its Earnings Potential?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether Kung Sing Engineering's (TPE:5521) statutory profits are a good guide to its underlying earnings.

While Kung Sing Engineering was able to generate revenue of NT$7.68b in the last twelve months, we think its profit result of NT$1.37b was more important.

View our latest analysis for Kung Sing Engineering

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. As a result, we'll today take a look at how dilution and cashflow shape our understanding of Kung Sing Engineering's earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Kung Sing Engineering.

A Closer Look At Kung Sing Engineering'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. The ratio shows us how much a company's profit exceeds its FCF.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Kung Sing Engineering has an accrual ratio of -0.32 for the year to September 2020. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of NT$3.1b in the last year, which was a lot more than its statutory profit of NT$1.37b. Kung Sing Engineering's free cash flow improved over the last year, which is generally good to see. Notably, the company has issued new shares, thus diluting existing shareholders and reducing 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. Kung Sing Engineering expanded the number of shares on issue by 29% over the last year. That means its earnings are split among a greater number of shares. 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 Kung Sing Engineering's EPS by clicking here.

A Look At The Impact Of Kung Sing Engineering's Dilution on Its Earnings Per Share (EPS).

We don't have any data on the company's profits from three years ago. The good news is that profit was up 152,170% in the last twelve months. But EPS was less impressive, up only 121,166% in that time. Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Kung Sing Engineering 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 Kung Sing Engineering's Profit Performance

At the end of the day, Kung Sing Engineering 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. Considering all the aforementioned, we'd venture that Kung Sing Engineering's profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example - Kung Sing Engineering has 1 warning sign we think you should be aware of.

Our examination of Kung Sing Engineering has focussed on certain factors that can make its earnings look better than they are. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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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