We Think NeoPhotonics's (NYSE:NPTN) Statutory Profit Might Understate Its Earnings Potential

Broadly speaking, profitable businesses are less risky than unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. Today we'll focus on whether this year's statutory profits are a good guide to understanding NeoPhotonics (NYSE:NPTN).

We like the fact that NeoPhotonics made a profit of US$9.20m on its revenue of US$406.3m, in the last year. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.

See our latest analysis for NeoPhotonics

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. As a result, we think it's well worth considering what NeoPhotonics' cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. 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.

Zooming In On NeoPhotonics' 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. 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to September 2020, NeoPhotonics had an accrual ratio of -0.39. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of US$53m, well over the US$9.20m it reported in profit. NeoPhotonics' free cash flow improved over the last year, which is generally good to see.

Our Take On NeoPhotonics' Profit Performance

As we discussed above, NeoPhotonics' accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think NeoPhotonics' underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And it's also positive that the company showed enough improvement to book a profit this year, after losing money last year. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Every company has risks, and we've spotted 3 warning signs for NeoPhotonics (of which 1 can't be ignored!) you should know about.

Today we've zoomed in on a single data point to better understand the nature of NeoPhotonics' profit. 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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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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