Are Espey Mfg. & Electronics's (NYSEMKT:ESP) Statutory Earnings A Good Reflection Of Its Earnings Potential?

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. 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. This article will consider whether Espey Mfg. & Electronics' (NYSEMKT:ESP) statutory profits are a good guide to its underlying earnings.

While Espey Mfg. & Electronics was able to generate revenue of US$32.9m in the last twelve months, we think its profit result of US$1.27m was more important. Happily, it has grown both its profit and revenue over the last three years (but not in the last year), as you can see in the chart below.

View our latest analysis for Espey Mfg. & Electronics

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. So today we'll examine what Espey Mfg. & Electronics' cashflow and its expanding share count tell us about the nature of its profits. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Espey Mfg. & Electronics.

A Closer Look At Espey Mfg. & Electronics' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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.

Espey Mfg. & Electronics has an accrual ratio of -0.11 for the year to September 2020. Therefore, its statutory earnings were quite a lot less than its free cashflow. In fact, it had free cash flow of US$3.5m in the last year, which was a lot more than its statutory profit of US$1.27m. Espey Mfg. & Electronics shareholders are no doubt pleased that free cash flow improved over the last twelve months. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. Espey Mfg. & Electronics expanded the number of shares on issue by 13% over the last year. As a result, its net income is now split between a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. Check out Espey Mfg. & Electronics' historical EPS growth by clicking on this link.

A Look At The Impact Of Espey Mfg. & Electronics' Dilution on Its Earnings Per Share (EPS).

Espey Mfg. & Electronics has improved its profit over the last three years, with an annualized gain of 8.5% in that time. Net profit actually dropped by 46% in the last year. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 47%. So you can see that the dilution has had a bit of an impact on shareholders. Therefore, the dilution is having a noteworthy influence on shareholder returns. And so, you can see quite clearly that dilution is influencing shareholder earnings.

If Espey Mfg. & Electronics' EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. 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 Espey Mfg. & Electronics' Profit Performance

In conclusion, Espey Mfg. & Electronics 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 Espey Mfg. & Electronics'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. To that end, you should learn about the 5 warning signs we've spotted with Espey Mfg. & Electronics (including 1 which is potentially serious).

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. 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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