Here's Why We Don't Think Far EasTone Telecommunications's (TPE:4904) Statutory Earnings Reflect Its Underlying Earnings Potential

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. This article will consider whether Far EasTone Telecommunications' (TPE:4904) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Far EasTone Telecommunications made a profit of NT$8.60b on revenue of NT$77.9b. Below, you can see that both its revenue and its profit have fallen over the last three years.

Check out our latest analysis for Far EasTone Telecommunications

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. Today, we'll discuss Far EasTone Telecommunications' free cashflow relative to its earnings, and consider what that tells us about the company. 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.

Examining Cashflow Against Far EasTone Telecommunications' 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. The ratio shows us how much a company's profit exceeds its FCF.

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.

For the year to September 2020, Far EasTone Telecommunications had an accrual ratio of 0.30. 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. Even though it reported a profit of NT$8.60b, a look at free cash flow indicates it actually burnt through NT$26b in the last year. It's worth noting that Far EasTone Telecommunications generated positive FCF of NT$14b a year ago, so at least they've done it in the past. The good news for shareholders is that Far EasTone Telecommunications' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Our Take On Far EasTone Telecommunications' Profit Performance

Far EasTone Telecommunications' accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Therefore, it seems possible to us that Far EasTone Telecommunications' true underlying earnings power is actually less than its statutory profit. The good news is that its earnings per share increased slightly in the last year. 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. So while earnings quality is important, it's equally important to consider the risks facing Far EasTone Telecommunications at this point in time. Every company has risks, and we've spotted 4 warning signs for Far EasTone Telecommunications (of which 3 can't be ignored!) you should know about.

This note has only looked at a single factor that sheds light on the nature of Far EasTone Telecommunications' profit. 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. 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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