Zedge, Inc. (NYSEMKT:ZDGE) recently posted some strong earnings, and the market responded positively. Our analysis found some more factors that we think are good for shareholders.
Examining Cashflow Against Zedge's 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. This ratio tells us how much of a company's profit is not backed by free cashflow.
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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".
Zedge has an accrual ratio of -0.17 for the year to January 2021. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of US$4.2m during the period, dwarfing its reported profit of US$3.47m. Given that Zedge had negative free cash flow in the prior corresponding period, the trailing twelve month resul of US$4.2m would seem to be a step in the right direction. 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. Zedge expanded the number of shares on issue by 11% over the last year. As a result, its net income is now split between 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. You can see a chart of Zedge's EPS by clicking here.
A Look At The Impact Of Zedge's Dilution on Its Earnings Per Share (EPS).
Zedge was losing money three years ago. And even focusing only on the last twelve months, we don't have a meaningful growth rate because it made a loss a year ago, too. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. Therefore, the dilution is having a noteworthy influence on shareholder returns.
If Zedge'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 the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.
Our Take On Zedge's Profit Performance
In conclusion, Zedge 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. Considering all the aforementioned, we'd venture that Zedge's profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. If you want to do dive deeper into Zedge, you'd also look into what risks it is currently facing. You'd be interested to know, that we found 2 warning signs for Zedge and you'll want to know about them.
Our examination of Zedge has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. 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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