Hi readers, imagine a day, when you get home from work, one of your invested companies has released its latest financial report, showing a whooping 100% surge in its net profit. By looking at the triple-digit earning growth, you feel excited about tomorrow’s market reaction to share price. In your mind, “after all those long waits, finally tomorrow is the day that the market will notice about my long time holding, and i’m pretty sure they are going to push up the share price like crazy. “ On the next day, first few minutes of the market opening, the company’s share price surged by 10% with gap up and large trading volume. But wait a minute, have you checked the reason why the company’s earning has shown such drastic surge, yet its revenue only appears to be rather flat? Is there any disposal of properties, investments during this financial period? Or the company’s newly acquired subsidiary has finally contributing to the company’s earnings?
Have you found any of yourself being in that scenario or reacting similarly? Do not worry, it is absolutely normal.
Today, let us talk a little bit more about company’s earnings. Very often we tend to take number in financial reports as it is, and giving too much hype when the net profit of the company has improved or fallen significantly. Just like many people in the market, there is nothing wrong for us to be happy when we see companies that we invested in have released good growth in their profits, but let us calm down and find out what is the reason behind the posted growth or setback.
Why need “clean” earnings?
Profitability of company is closely related to the business growth. Generally, there are two types of growth that will impact the income of the a company: organic and inorganic growth. According to Investopedia, organic growth is the growth rate a company can achieve by increasing output and enhancing sales internally. This does not include profits or growth acquired from takeovers, acquisitions or mergers. In other word, growth is something that the company need to increase their profitability permanently. As a long term investor, a “clean” income statement that could represent the company’s true earning capability is something that we really need to understand the business. The net profit shown in the income statement is inclusive of everything including items that have no or little relation to the company growth. Unfortunately, these items could impact profit margin and net profit, which will sometimes paint a wrong picture to the investors. While it is the company’s duty to be transparent in their income statement, it is our duty to identify and exclude items that are not generated from the company’s core business.
Case Study 1: Ajisen China Holdings Limited (HKEX)
We have come across this company while searching for gems in HKEX. Ajisen Ramen China Holdings Limited is a company which operates Japan-based fast food restaurants and produces own brand instant noodle. When we went through its financial report, we thought this will be a good example for this topic.
Taken from Ajisen Ramen China Holdings Limited Annual Report FY 2016
Looking at Ajisen’s income statement, probably everyone could notice that the amount from “Other income” and “Other gains and losses” are significant that it could greatly impact the overall net profit. Let’s see how much can this impact the income statement. Below is the profitability chart for the past 5 years:
As shown in the chart, both revenue and gross profit of company are on decline. In FY16 Q2, there’s a significant jump of 247% in its net profit of RMB 787 mil, which represents 26.6% net profit margin, a huge jump compares to the previous years. As we can see, this is due to the RMB 849 mil other incomes. From the breakdown of the other incomes, we noticed that most of them are non recurring or has no direct relation to the business profitability. One may spend some time to determine which items should be included or removed, to make things easier, we will remove all other incomes.
Breakdown of Other Income and Other Gains and Losses
After excluding the portion of other incomes, we estimated the net profit without other income, or Normalized earning is about RMB 204 mil, which represents a net profit margin of 6.9%. Now, it is safer for us to use the “cleaner” figures to calculate some common profitability metrics such as PE, ROE, ROA for company analysis. As an example, we have tabulated the calculated result of key metrics in the table.
Comparison using EPS with and w/o other incomes based on FY16 Q2 (TTM)
Case Study 2: Focus Lumber Bhd (KLSE)
Back in our homeland, remember during the significant weakening of RM against USD in 2015, our market was hype about Focus Lumber Bhd (FLBHD) due to its export oriented business.
Taken from FLBHD Annual Report FY2015
We can see the other income component was mainly consist of forex gain. After removing the other income, the result was tabulated as below:
Comparison using EPS with and w/o other incomes based on FY15
We also like to recommend readers to check out this write up by Contrarian Investing for another way to find out the true earning power of a company in the case of FLBHD.
To wrap up the topic for this post, the occurrence of other income does not determine the quality of the company, and may sometimes serves as a catalyst, but we should not forget its evil side for misleading investors in doing their company analysis or investment decision. In future, whenever a financial report is released, make sure you pay extra attention to the other income. All the best and take care.