Despite posting some strong earnings, the market for Green Economy Development Limited's (HKG:1315) stock hasn't moved much. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

A Closer Look At Green Economy Development's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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".

Over the twelve months to March 2024, Green Economy Development recorded an accrual ratio of -0.17. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of HK$52m during the period, dwarfing its reported profit of HK$18.2m. Notably, Green Economy Development had negative free cash flow last year, so the HK$52m it produced this year was a welcome improvement. 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 Green Economy Development.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. In fact, Green Economy Development increased the number of shares on issue by 38% over the last twelve months by issuing new shares. That means its earnings are split among a greater number of shares. 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. Check out Green Economy Development's historical EPS growth by clicking on this link.

How Is Dilution Impacting Green Economy Development's Earnings Per Share (EPS)?

We don't have any data on the company's profits from three years ago. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. So you can see that the dilution has had a fairly significant impact on shareholders.

In the long term, if Green Economy Development's earnings per share can increase, then the share price should too. 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.

Our Take On Green Economy Development's Profit Performance

In conclusion, Green Economy Development 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 Green Economy Development's profits are an apt reflection of its underlying potential for profit. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Green Economy Development is showing 4 warning signs in our investment analysis and 3 of those are potentially serious...

Our examination of Green Economy Development has focussed on certain factors that can make its earnings look better than they are. 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 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com