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. Today we'll focus on whether this year's statutory profits are a good guide to understanding Art Emperor Technology & Culture (GTSM:6650).
We like the fact that Art Emperor Technology & Culture made a profit of NT$33.3m on its revenue of NT$120.8m, in the last year. In the last few years both its revenue and its profit have fallen, as you can see in the chart below.
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. Therefore, today we'll take a look at Art Emperor Technology & Culture's cashflow, share issues and unusual items with a view to better understanding the nature of its statutory earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Art Emperor Technology & Culture.
A Closer Look At Art Emperor Technology & Culture'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. 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.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.
Art Emperor Technology & Culture has an accrual ratio of -0.66 for the year to June 2020. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of NT$115m during the period, dwarfing its reported profit of NT$33.3m. Notably, Art Emperor Technology & Culture had negative free cash flow last year, so the NT$115m it produced this year was a welcome improvement. Having said that, there is more to consider. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares.
One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Art Emperor Technology & Culture expanded the number of shares on issue by 16% over the last year. Therefore, each share now receives a smaller portion of profit. 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 Art Emperor Technology & Culture's EPS by clicking here.
A Look At The Impact Of Art Emperor Technology & Culture's Dilution on Its Earnings Per Share (EPS).
Art Emperor Technology & Culture's net profit dropped by 19% per year over the last three years. The good news is that profit was up 56% in the last twelve months. But EPS was less impressive, up only 48% in that time. 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 Art Emperor Technology & Culture 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 the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.
The Impact Of Unusual Items On Profit
Art Emperor Technology & Culture's profit was reduced by unusual items worth NT$4.6m 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 Art Emperor Technology & Culture to produce a higher profit next year, all else being equal.
Our Take On Art Emperor Technology & Culture's Profit Performance
Summing up, Art Emperor Technology & Culture's accrual ratio and its unusual items suggest that its statutory earnings were temporarily depressed (and could bounce back), while the dilution is a negative for shareholders. Based on these factors, we think Art Emperor Technology & Culture's earnings potential is at least as good as it seems, and maybe even better! Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. To help with this, we've discovered 5 warning signs (1 doesn't sit too well with us!) that you ought to be aware of before buying any shares in Art Emperor Technology & Culture.
After our examination into the nature of Art Emperor Technology & Culture's profit, we've come away optimistic for the company. 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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