We're Not So Sure You Should Rely on Sentelic's (GTSM:4945) Statutory Earnings

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 Sentelic's (GTSM:4945) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Sentelic made a profit of NT$54.1m on revenue of NT$398.1m. One positive is that it has grown both its profit and its revenue, over the last few years.

Check out our latest analysis for Sentelic

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 Sentelic's earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Sentelic.

Zooming In On Sentelic'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to September 2020, Sentelic recorded an accrual ratio of 0.25. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Indeed, in the last twelve months it reported free cash flow of NT$23m, which is significantly less than its profit of NT$54.1m. Sentelic's free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings. One positive for Sentelic shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. In fact, Sentelic increased the number of shares on issue by 16% over the last twelve months by issuing new shares. As a result, its net income is now split between a greater number of shares. 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. Check out Sentelic's historical EPS growth by clicking on this link.

How Is Dilution Impacting Sentelic's Earnings Per Share? (EPS)

As you can see above, Sentelic has been growing its net income over the last few years, with an annualized gain of 273% over three years. But EPS was only up 110% per year, in the exact same period. However, net income was pretty flat over the last year with a miniscule decrease. Earnings per share are pretty much flat, too over the last twelve months, but EPS growth came in below below net income growth. 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.

If Sentelic's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. 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 Sentelic's Profit Performance

In conclusion, Sentelic has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). Considering all this we'd argue Sentelic's profits probably give an overly generous impression of its sustainable level of profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. To that end, you should learn about the 5 warning signs we've spotted with Sentelic (including 1 which is a bit unpleasant).

Our examination of Sentelic has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. 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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