Arch Meter's (TWSE:4588) Earnings Are Built On Soft Foundations

Solid profit numbers didn't seem to be enough to please Arch Meter Corporation's (TWSE:4588) shareholders. We think that they might be concerned about some underlying details that our analysis found.

See our latest analysis for Arch Meter

Zooming In On Arch Meter's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. 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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Arch Meter has an accrual ratio of 0.70 for the year to June 2024. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of NT$572m despite its profit of NT$149.6m, mentioned above. We saw that FCF was NT$4.6m a year ago though, so Arch Meter has at least been able to generate positive FCF in the past. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Arch Meter.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. As it happens, Arch Meter issued 10% more new shares over the last year. As a result, its net income is now split between a greater number of shares. 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 Arch Meter's EPS by clicking here.

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

Arch Meter has improved its profit over the last three years, with an annualized gain of 392% in that time. In comparison, earnings per share only gained 336% over the same period. And in the last year the company managed to bump profit up by 13%. On the other hand, earnings per share are only up 8.3% in that time. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, earnings per share growth should beget share price growth. So Arch Meter 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 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 Arch Meter's Profit Performance

In conclusion, Arch Meter 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. For the reasons mentioned above, we think that a perfunctory glance at Arch Meter's statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about Arch Meter as a business, it's important to be aware of any risks it's facing. For example, we've found that Arch Meter has 5 warning signs (2 are potentially serious!) that deserve your attention before going any further with your analysis.

Our examination of Arch Meter 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. 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.