Vital Farms, Inc.'s (NASDAQ:VITL) earnings announcement last week was disappointing for investors, despite the decent profit numbers. We did some digging and actually think they are being unnecessarily pessimistic.

Zooming In On Vital Farms' 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 September 2024, Vital Farms recorded an accrual ratio of -0.12. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. To wit, it produced free cash flow of US$61m during the period, dwarfing its reported profit of US$50.0m. Vital Farms' 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.

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.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. In fact, Vital Farms increased the number of shares on issue by 5.3% 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 Vital Farms' historical EPS growth by clicking on this link.

How Is Dilution Impacting Vital Farms' Earnings Per Share (EPS)?

As it happens, we don't know how much the company made or lost three years ago, because we don't have the data. The good news is that profit was up 144% in the last twelve months. On the other hand, earnings per share are only up 136% over the same period. And so, you can see quite clearly that dilution is influencing shareholder earnings.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Vital Farms 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.

Our Take On Vital Farms' Profit Performance

At the end of the day, Vital Farms is diluting shareholders which will dampen earnings per share growth, but its accrual ratio showed it can back up its profits with free cash flow. After taking into account all these factors, we think that Vital Farms' statutory results are a decent reflection of its underlying earnings power. 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. Case in point: We've spotted 1 warning sign for Vital Farms you should be aware of.

Our examination of Vital Farms 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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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.