We Think Magnolia Oil & Gas' (NYSE:MGY) Profit Is Only A Baseline For What They Can Achieve

By
Simply Wall St
Published
November 08, 2021
NYSE:MGY
Source: Shutterstock

The subdued stock price reaction suggests that Magnolia Oil & Gas Corporation's (NYSE:MGY) strong earnings didn't offer any surprises. Investors are probably missing some underlying factors which are encouraging for the future of the company.

See our latest analysis for Magnolia Oil & Gas

earnings-and-revenue-history
NYSE:MGY Earnings and Revenue History November 9th 2021

Examining Cashflow Against Magnolia Oil & Gas' 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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Magnolia Oil & Gas has an accrual ratio of -0.11 for the year to September 2021. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. To wit, it produced free cash flow of US$404m during the period, dwarfing its reported profit of US$293.1m. Magnolia Oil & Gas shareholders are no doubt pleased that free cash flow improved over the last twelve months.

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.

Our Take On Magnolia Oil & Gas' Profit Performance

Magnolia Oil & Gas' accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Based on this observation, we consider it likely that Magnolia Oil & Gas' statutory profit actually understates its earnings potential! And it's also positive that the company showed enough improvement to book a profit this year, after losing money last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Magnolia Oil & Gas is showing 3 warning signs in our investment analysis and 1 of those shouldn't be ignored...

This note has only looked at a single factor that sheds light on the nature of Magnolia Oil & Gas' profit. 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 that insiders are buying to be useful.

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