Why Diamondback Energy's (NASDAQ:FANG) Healthy Earnings Aren’t As Good As They Seem

Diamondback Energy, Inc. (NASDAQ:FANG) posted some decent earnings, but shareholders didn't react strongly. Our analysis has found some concerning factors which weaken the profit's foundation.

Check out our latest analysis for Diamondback Energy

Examining Cashflow Against Diamondback Energy'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to December 2024, Diamondback Energy recorded an accrual ratio of 0.23. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Over the last year it actually had negative free cash flow of US$5.4b, in contrast to the aforementioned profit of US$3.32b. We saw that FCF was US$1.2b a year ago though, so Diamondback Energy 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.

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. Diamondback Energy expanded the number of shares on issue by 62% over the last year. That means its earnings are split among 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. Check out Diamondback Energy's historical EPS growth by clicking on this link.

A Look At The Impact Of Diamondback Energy's Dilution On Its Earnings Per Share (EPS)

As you can see above, Diamondback Energy has been growing its net income over the last few years, with an annualized gain of 53% over three years. In comparison, earnings per share only gained 27% over the same period. And in the last year the company managed to bump profit up by 6.3%. But earnings per share are actually down 10%, over the last twelve months. Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

In the long term, if Diamondback Energy's earnings per share can increase, then the share price should too. 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 Diamondback Energy's Profit Performance

As it turns out, Diamondback Energy couldn't match its profit with cashflow and its dilution means that shareholders own less of the company than the did before (unless they bought more shares). For the reasons mentioned above, we think that a perfunctory glance at Diamondback Energy's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Diamondback Energy, you'd also look into what risks it is currently facing. To that end, you should learn about the 4 warning signs we've spotted with Diamondback Energy (including 2 which shouldn't be ignored).

Our examination of Diamondback Energy 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.