Novatek Microelectronics (TPE:3034) Is Growing Earnings But Are They A Good Guide?

As a general rule, we think profitable companies are less risky than companies that lose money. 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. In this article, we'll look at how useful this year's statutory profit is, when analysing Novatek Microelectronics (TPE:3034).

It's good to see that over the last twelve months Novatek Microelectronics made a profit of NT$9.98b on revenue of NT$74.0b. One positive is that it has grown both its profit and its revenue, over the last few years.

View our latest analysis for Novatek Microelectronics

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 Novatek Microelectronics' 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.

Zooming In On Novatek Microelectronics' 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. 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.

For the year to September 2020, Novatek Microelectronics had an accrual ratio of 0.31. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. To wit, it produced free cash flow of NT$4.9b during the period, falling well short of its reported profit of NT$9.98b. Novatek Microelectronics' 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.

Our Take On Novatek Microelectronics' Profit Performance

Novatek Microelectronics didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Because of this, we think that it may be that Novatek Microelectronics' statutory profits are better than its underlying earnings power. But on the bright side, its earnings per share have grown at an extremely impressive rate over the last three years. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. 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 3 warning signs we've spotted with Novatek Microelectronics (including 1 which is concerning).

This note has only looked at a single factor that sheds light on the nature of Novatek Microelectronics' profit. But there are plenty of other ways to inform your opinion of a company. 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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