The subdued market reaction suggests that Emperor Watch & Jewellery Limited's (HKG:887) recent earnings didn't contain any surprises. We think that investors are worried about some weaknesses underlying the earnings.
Examining Cashflow Against Emperor Watch & Jewellery's Earnings
In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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.
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. 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, Emperor Watch & Jewellery recorded an accrual ratio of -0.10. That indicates that its free cash flow was a fair bit more than its statutory profit. In fact, it had free cash flow of HK$693m in the last year, which was a lot more than its statutory profit of HK$256.7m. Emperor Watch & Jewellery's free cash flow improved over the last year, which is generally good to see. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Emperor Watch & Jewellery.
One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. In fact, Emperor Watch & Jewellery increased the number of shares on issue by 7.0% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of Emperor Watch & Jewellery's EPS by clicking here.
A Look At The Impact Of Emperor Watch & Jewellery's Dilution On Its Earnings Per Share (EPS)
As you can see above, Emperor Watch & Jewellery has been growing its net income over the last few years, with an annualized gain of 25% over three years. Net profit actually dropped by 14% in the last year. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 14%. Therefore, the dilution is having a noteworthy influence on shareholder returns.
If Emperor Watch & Jewellery's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.
Our Take On Emperor Watch & Jewellery's Profit Performance
In conclusion, Emperor Watch & Jewellery 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. Given the contrasting considerations, we don't have a strong view as to whether Emperor Watch & Jewellery's profits are an apt reflection of its underlying potential for profit. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. In terms of investment risks, we've identified 1 warning sign with Emperor Watch & Jewellery, and understanding this should be part of your investment process.
Our examination of Emperor Watch & Jewellery has focussed on certain factors that can make its earnings look better than they are. But there is always more to discover if you are capable of focussing your mind on minutiae. 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. 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.