VerifyMe, Inc. (NASDAQ:VRME) recently released a strong earnings report, and the market responded by raising the share price. While the headline numbers were strong, we found some underlying problems once we started looking at what drove earnings.
A Closer Look At VerifyMe's Earnings
One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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 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".
VerifyMe has an accrual ratio of 1.20 for the year to September 2021. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of US$3.44m, a look at free cash flow indicates it actually burnt through US$3.6m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of US$3.6m, this year, indicates high risk. Having said that, there is more to consider. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares.
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. VerifyMe expanded the number of shares on issue by 30% 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. Check out VerifyMe's historical EPS growth by clicking on this link.
A Look At The Impact Of VerifyMe's Dilution on Its Earnings Per Share (EPS).
Three years ago, VerifyMe lost money. 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. But mathematics aside, it is always good to see when a formerly unprofitable business come good (though we accept profit would have been higher if dilution had not been required). Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.
If VerifyMe'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.
The Impact Of Unusual Items On Profit
Given the accrual ratio, it's not overly surprising that VerifyMe's profit was boosted by unusual items worth US$8.3m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. We can see that VerifyMe's positive unusual items were quite significant relative to its profit in the year to September 2021. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.
Our Take On VerifyMe's Profit Performance
VerifyMe didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. Meanwhile, the new shares issued mean that shareholders now own less of the company, unless they tipped in more cash themselves. On reflection, the above-mentioned factors give us the strong impression that VerifyMe'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. If you want to do dive deeper into VerifyMe, you'd also look into what risks it is currently facing. Every company has risks, and we've spotted 5 warning signs for VerifyMe (of which 3 don't sit too well with us!) 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 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.
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.
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