justification of profit

In a previous post I claimed that PEO was undervalued on the basis of a predicition of profit at 1.5 million. In order to complete this argument I should provide an analysis of why I think PEO's profit is likely to come out at this figure. This is what I'll provide now. I just posted this on the PEO forum:


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I've been getting into the profit prediction game somewhat this afternoon - pouring over the financial statements to see what I can see.

All signs point to at least 1.5 mill profit... (this could even be conservative)

There are a couple of things I'm looking at. Consider the balance sheet and make a comparison between end of year 04 and half year 05. Look at the cash figure in the current assets. It dropped in that six month period from 3,557,048 to 2,261,735. That's a loss in this particular asset of 1.29 million dollars. This amount directly came off the bottom line of the company. Keep this in mind as we progress.

Now one way of predicting the profit would be to take the percentage change from end of 04 to half year 05 and divide that through the 05 figure - and do this for each asset class. As an example - If receivables in 04 were 100k and in 05 were 150k then it grew by 50 percent, so we are making the assumption that the rate of growth was the same and predicting that for the annual it would be 225. (150 / 0.6666666). If the 05 figure dropped, then for the annual, also continue the drop by the appropriate percentage.

Do this also for the liabilities.

Bear in mind a couple of exceptions. We know that cash as at june 30 was 2,610,000. So just plug this figure in. And amortisation is at a fixed rate - so drop the goodwill asset by about 950k.

If you work through this procedure and then subtract the predicted net assets from the net assets of the half year - you get a net profit of just over 2 million.

To say that assets and liabilites grew (or shrank) at the same rate for the second half that they did for the first is probably a pretty crude assumption. However it gives you a startling demonstrating of the effects of the improved cash flow position.

When we look at this we can see why the net profit comes out looking so improved. If we took every asset and liabilities class and applied the formula everything would pretty much come out the same. But the change in the cash flow position changes everything. From end of 04 to end of half 05 the cash assets dropped by 1.29 million. If we applied the rule to this assets class (which we haven't) then we would expect a cash position of about 1.4 million. But we KNOW from the 4c that this didn't happen. It improved from 2.26 to 2.61 and we have plugged that in. So it's like adding 1.2 million to the bottom line (because it is 1.2 million better than a straight application of the rule would suggest).

The other big factor which makes things come out so good is the rate of improvement that the receivables enjoyed in the first half as opposed to the rate of increase of the payables. This is probably what explains the improvement in the cash flow - (which is evidence to say that my assumption may not be too crude after all). Take a look. Receivables improved from 11,941,189 to 13,860,247 in the first half. Assuming the same rate of increase we get: 16,116,566. But the rate of increase of the payables was 14,477,451 to 14,869,338. Again with the same assumption in place - end of year 05 payables looks around: 15,271,832. You can see the massive difference here. Receivables was growing much faster than payables.

The lesson here? Well I think it would be the joy of a having a percentage amount of your cost base being fixed. The is one of the key things that negative commentary of PEO seems to miss. Because things were so borderline in the last report everyone thought that it just a case of money in, money out. They didn't look at the rate of improvement. They didn't factor in that some of PEO's costs are fixed - that it was on the cusp of great things!

I'm taking 500k off my prediction simply because there are always costs that crop up that you can't account for.

Of course - if my basic assumption is wrong then too bad... but we'll see...