Even though Ari Real Estate (Arena) Investment Ltd (TLV:ARIN) posted strong earnings recently, the stock hasn’t reacted in a large way. We think that investors might be worried about the foundations the earnings are built on.
Examining Cashflow Against Ari Real Estate (Arena) Investment’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. 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”.
For the year to December 2021, Ari Real Estate (Arena) Investment had an accrual ratio of 0.23. Therefore, we know that it’s free cashflow was significantly lower than its statutory profit, which is hardly a good thing. In fact, it had free cash flow of ₪8.8m in the last year, which was a lot less than its statutory profit of ₪193.8m. Ari Real Estate (Arena) Investment shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. 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. The good news for shareholders is that Ari Real Estate (Arena) Investment’s accrual ratio was much better last year, so this year’s poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Ari Real Estate (Arena) Investment.
To understand the value of a company’s earnings growth, it is imperative to consider any dilution of shareholders’ interests. Ari Real Estate (Arena) Investment expanded the number of shares on issue by 53% over the last year. That means its earnings are split among 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 Ari Real Estate (Arena) Investment’s EPS by clicking here.
How Is Dilution Impacting Ari Real Estate (Arena) Investment’s Earnings Per Share? (EPS)
Ari Real Estate (Arena) Investment was losing money three years ago. On the bright side, in the last twelve months it grew profit by 1,586%. But EPS was less impressive, up only 1,562% in that time. So you can see that the dilution has had a fairly significant impact on shareholders.
In the long term, earnings per share growth should beget share price growth. So it will certainly be a positive for shareholders if Ari Real Estate (Arena) Investment can grow EPS persistently. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company’s share price might grow.
The Impact Of Unusual Items On Profit
Given the accrual ratio, it’s not overly surprising that Ari Real Estate (Arena) Investment’s profit was boosted by unusual items worth ₪235m 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 Ari Real Estate (Arena) Investment’s positive unusual items were quite significant relative to its profit in the year to December 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 Ari Real Estate (Arena) Investment’s Profit Performance
Ari Real Estate (Arena) Investment 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. For all the reasons mentioned above, we think that, at a glance, Ari Real Estate (Arena) Investment’s statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. With this in mind, we wouldn’t consider investing in a stock unless we had a thorough understanding of the risks. For example, we’ve discovered 3 warning signs that you should run your eye over to get a better picture of Ari Real Estate (Arena) Investment.
Our examination of Ari Real Estate (Arena) Investment has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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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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.