First Advantage Corporation's (NASDAQ:FA) earnings announcement last week didn't impress shareholders. However, our analysis suggests that the soft headline numbers are getting counterbalanced by some positive underlying factors.
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. This ratio tells us how much of a company's profit is not backed by free cashflow.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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 September 2024, First Advantage had an accrual ratio of -0.11. That indicates that its free cash flow was a fair bit more than its statutory profit. In fact, it had free cash flow of US$142m in the last year, which was a lot more than its statutory profit of US$4.91m. First Advantage's free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. However, that's not the end of the story. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively.
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. First Advantage expanded the number of shares on issue by 19% 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 First Advantage's EPS by clicking here.
How Is Dilution Impacting First Advantage's Earnings Per Share (EPS)?
Unfortunately, First Advantage's profit is down 84% per year over three years. And even focusing only on the last twelve months, we see profit is down 88%. Like a sack of potatoes thrown from a delivery truck, EPS fell harder, down 88% in the same period. Therefore, the dilution is having a noteworthy influence on shareholder returns.
If First Advantage'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 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.
How Do Unusual Items Influence Profit?
First Advantage's profit was reduced by unusual items worth US$34m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. First Advantage took a rather significant hit from unusual items in the year to September 2024. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.
Our Take On First Advantage's Profit Performance
In conclusion, both First Advantage's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative, but the dilution means that per-share performance is weaker than the statutory profit numbers imply. Based on these factors, we think First Advantage's earnings potential is at least as good as it seems, and maybe even better! So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. While conducting our analysis, we found that First Advantage has 3 warning signs and it would be unwise to ignore them.
Our examination of First Advantage has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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.