Zero One Technology's (TWSE:3029) Solid Earnings May Rest On Weak Foundations

The recent earnings posted by Zero One Technology Co., Ltd. (TWSE:3029) were solid, but the stock didn't move as much as we expected. We believe that shareholders have noticed some concerning factors beyond the statutory profit numbers.

See our latest analysis for Zero One Technology

Zooming In On Zero One Technology'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). 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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 2024, Zero One Technology recorded an accrual ratio of 0.26. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. To wit, it produced free cash flow of NT$18m during the period, falling well short of its reported profit of NT$779.3m. Zero One Technology shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings. One positive for Zero One Technology 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zero One Technology.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Zero One Technology expanded the number of shares on issue by 8.2% 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. Check out Zero One Technology's historical EPS growth by clicking on this link.

A Look At The Impact Of Zero One Technology's Dilution On Its Earnings Per Share (EPS)

As you can see above, Zero One Technology has been growing its net income over the last few years, with an annualized gain of 55% over three years. But EPS was only up 24% per year, in the exact same period. And over the last 12 months, the company grew its profit by 18%. But in comparison, EPS only increased by 16% over the same period. And so, you can see quite clearly that dilution is influencing shareholder earnings.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So Zero One Technology 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.

Our Take On Zero One Technology's Profit Performance

In conclusion, Zero One Technology has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means its earnings per share growth is weaker than its profit growth. Considering all this we'd argue Zero One Technology's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Zero One Technology at this point in time. To that end, you should learn about the 3 warning signs we've spotted with Zero One Technology (including 1 which is significant).

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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 with significant insider holdings 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.