United Homes Group's (NASDAQ:UHG) Solid Earnings May Rest On Weak Foundations

United Homes Group, Inc. (NASDAQ:UHG) just released a solid earnings report, and the stock displayed some strength. However, we think that shareholders should be cautious as we found some worrying factors underlying the profit.

Check out our latest analysis for United Homes Group

Examining Cashflow Against United Homes Group'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). 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.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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. 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 2023, United Homes Group recorded an accrual ratio of 1.12. That means it didn't generate anywhere near enough free cash flow to match its profit. As a general rule, that bodes poorly for future profitability. To wit, it produced free cash flow of US$60m during the period, falling well short of its reported profit of US$202.6m. Notably United Homes Group's free cash flow was stable over the last year. However, that's not the end of the story. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of United Homes Group.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, United Homes Group issued 12% more new shares over the last year. That means its earnings are split among 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 United Homes Group's historical EPS growth by clicking on this link.

A Look At The Impact Of United Homes Group's Dilution On Its Earnings Per Share (EPS)

As you can see above, United Homes Group has been growing its net income over the last few years, with an annualized gain of 458% over three years. In contrast, earnings per share were actually down by 93% per year, in the exact same period. And the 151% profit boost in the last year certainly seems impressive at first glance. But in comparison, EPS only increased by 780% over the same period. And so, you can see quite clearly that dilution is influencing shareholder earnings.

In the long term, earnings per share growth should beget share price growth. So United Homes Group 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.

The Impact Of Unusual Items On Profit

United Homes Group's profit suffered from unusual items, which reduced profit by US$4.9m in the last twelve months. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. If United Homes Group doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On United Homes Group's Profit Performance

In conclusion, United Homes Group's accrual ratio suggests that its statutory earnings are not backed by cash flow; but the fact unusual items actually weighed on profit may create upside if those unusual items to not recur. And the dilution means that per-share results are weaker than the bottom line might imply. Considering all this we'd argue United Homes Group'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 United Homes Group at this point in time. For example, United Homes Group has 4 warning signs (and 1 which is a bit concerning) we think you should know about.

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 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. 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.