Garrett Motion's (NASDAQ:GTX) Soft Earnings Are Actually Better Than They Appear

A lackluster earnings announcement from Garrett Motion Inc. (NASDAQ:GTX) last week didn't sink the stock price. However, we believe that investors should be aware of some underlying factors which may be of concern.

View our latest analysis for Garrett Motion

A Closer Look At Garrett Motion's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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.

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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to March 2024, Garrett Motion had an accrual ratio of -0.46. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of US$350m in the last year, which was a lot more than its statutory profit of US$6.00m. Garrett Motion shareholders are no doubt pleased that free cash flow improved over the last twelve months. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future 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.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. In fact, Garrett Motion increased the number of shares on issue by 248% over the last twelve months by issuing new shares. That means its earnings are split among a greater number of shares. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. Check out Garrett Motion's historical EPS growth by clicking on this link.

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

Garrett Motion's net profit dropped by 86% per year over the last three years. Even looking at the last year, profit was still down 88%. Sadly, earnings per share fell further, down a full 96% in that time. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

If Garrett Motion'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 Garrett Motion's Profit Performance

In conclusion, Garrett Motion has a strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share are dropping faster than its profit. Given the contrasting considerations, we don't have a strong view as to whether Garrett Motion's profits are an apt reflection of its underlying potential for profit. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For instance, we've identified 4 warning signs for Garrett Motion (2 make us uncomfortable) you should be familiar with.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there is always more to discover if you are capable of focussing your mind on minutiae. 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 that insiders are buying 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.