This article was originally published on Simply Wall St News.

Roku, Inc. ( NASDAQ:ROKU ) operates an ad-based TV streaming service. Subscribers can watch Roku original shows, as well as shows from other platforms.

Roku’s business model is dependent on the number of users, since they make money from adverts on streaming. The current user account base is 53.6m, and grew by 35% from last year.

NasdaqGS:ROKU 2021 Investor presentation

Roku became profitable this year and just reported healthy earnings but the stock price didn't move much.

We think that investors may have missed some encouraging factors underlying the profit figures.

Check out our latest analysis for Roku

NasdaqGS:ROKU Earnings and Revenue History June 7th 2021

Examining Cash Flow Against Roku's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio.

The ratio shows us how much a company's profit exceeds its Free Cash Flow (FCF). This is important because companies with net profits that greatly exceed FCF may be engaging in “ aggressive ” booking strategies, which will show up as a stagnation in EPS growth down the line and negatively impact the stock.

What we are looking for are companies that efficiently convert sales to cash and have a low rate of accruals (promises for future income).

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. A high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow.

To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

As you can see from the chart above, FCF is usually higher than earnings. This means that profit is efficiently converted to cash, and that the company has engaged in cash generation from alternative sources - such as issuing new shares.

Over the twelve months to March 2021, Roku recorded an accrual ratio of -0.12. That implies it has good cash conversion, and shows that its free cash flow solidly exceeded its profit last year.

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.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders.

Roku diluted its shares on issue by 9.7% over the last year. That means its earnings are split among a greater number of shares and is a negative signal telling investors that Roku cannot finance a portion of their projects by organic sales.

Key Takeaways

In conclusion, Roku has a strong cash flow relative to earnings, but the dilution means its earnings per share are dropping faster than its profit.

As a company, Roku has a clean business model with strong cash flows.

Their products are well positioned within a target audience that prefer free streaming with ads instead of paid subscriptions. The company will have an opportunity to expand as consumers may get overwhelmed with a large number of streaming platforms and ultimately decide to revert to a free service.

If you want to dive deeper into Roku, you'd also look into what risks it is currently facing. For example, we've discovered 3 warning signs that you should run over to get a better picture of Roku.

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

But you can always delve into different but related areas that will help you make a decision.

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 that insiders are buying.

Simply Wall St analyst Goran Damchevski and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. 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.

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