We Think Sunonwealth Electric Machine Industry's (TWSE:2421) Healthy Earnings Might Be Conservative

The market seemed underwhelmed by the solid earnings posted by Sunonwealth Electric Machine Industry Co., Ltd. (TWSE:2421) recently. We have done some analysis, and found some encouraging factors that we believe the shareholders should consider.

View our latest analysis for Sunonwealth Electric Machine Industry

Zooming In On Sunonwealth Electric Machine Industry'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. 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. 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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to December 2023, Sunonwealth Electric Machine Industry had an accrual ratio of -0.13. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. Indeed, in the last twelve months it reported free cash flow of NT$1.9b, well over the NT$1.33b it reported in profit. Sunonwealth Electric Machine Industry shareholders are no doubt pleased that free cash flow improved over the last twelve months. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future 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.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. In fact, Sunonwealth Electric Machine Industry increased the number of shares on issue by 8.6% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of Sunonwealth Electric Machine Industry's EPS by clicking here.

How Is Dilution Impacting Sunonwealth Electric Machine Industry's Earnings Per Share (EPS)?

Sunonwealth Electric Machine Industry has improved its profit over the last three years, with an annualized gain of 57% in that time. And at a glance the 22% gain in profit over the last year impresses. On the other hand, earnings per share are only up 19% in that time. So you can see that the dilution has had a bit of an impact on shareholders.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So Sunonwealth Electric Machine Industry shareholders will want to see that EPS figure continue to increase. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. 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 Sunonwealth Electric Machine Industry's Profit Performance

At the end of the day, Sunonwealth Electric Machine Industry 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. After taking into account all these factors, we think that Sunonwealth Electric Machine Industry's statutory results are a decent reflection of its underlying earnings power. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Every company has risks, and we've spotted 3 warning signs for Sunonwealth Electric Machine Industry you should know about.

Our examination of Sunonwealth Electric Machine Industry 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. 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.