Does Chong Hong Construction's (TPE:5534) Statutory Profit Adequately Reflect Its Underlying Profit?

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 Chong Hong Construction's (TPE:5534) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Chong Hong Construction made a profit of NT$2.47b on revenue of NT$7.72b. In the chart below, you can see that its profit and revenue have both grown over the last three years, although its profit has slipped in the last twelve months.

Check out our latest analysis for Chong Hong Construction

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. So today we'll look at what Chong Hong Construction's cashflow tells us about the quality of its 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.

A Closer Look At Chong Hong Construction's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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.

For the year to September 2020, Chong Hong Construction had an accrual ratio of 0.21. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of NT$2.47b, a look at free cash flow indicates it actually burnt through NT$2.9b in the last year. It's worth noting that Chong Hong Construction generated positive FCF of NT$2.1b a year ago, so at least they've done it in the past.

Our Take On Chong Hong Construction's Profit Performance

Chong Hong Construction's accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Because of this, we think that it may be that Chong Hong Construction's statutory profits are better than its underlying earnings power. Nonetheless, it's still worth noting that its earnings per share have grown at 6.6% 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. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example, we've found that Chong Hong Construction has 3 warning signs (2 shouldn't be ignored!) that deserve your attention before going any further with your analysis.

This note has only looked at a single factor that sheds light on the nature of Chong Hong Construction's profit. 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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