Revenue or Profit…Which Is More Important?
If you look at a company’s Income Statement, the top line is Revenue (sometimes shown as “Sales” or “Net Sales”).
No matter what it’s called, the idea is the same. It’s the money a company receives for delivering a good or service.
How Much of the Top Line Flows to the Bottom Line?
But of course, that’s only the beginning of the story. To start up and operate a business, a company also needs to spend money.
There are fixed costs such as lease payments, utility costs, and insurance. These costs don’t change regardless of production level.
And there are variable costs that change depending on production activity, such as input costs, shipping costs, hourly wages, etc.
Then there are costs like interest expense (if the company has debt) and depreciation (which is non-cash). And of course, taxes. Uncle Sam gets his cut, too.
It is only after deducting all expenses that you come up with the bottom line, the profit (if any) that go to the owners. In the case of corporations, the owners are the millions of shareholders.
That begs the question: what’s more important, revenue or profit (net income)?
First of all, you can’t have profit if you aren’t bringing in revenue, so revenue—and preferably growing revenue—is clearly very important.
But what about companies that generate tremendous amounts of revenue but also spend so much money that they are always in the red year after year?
Life Cycle Stage Matters
It depends on where the company is in its life cycle.
It’s common for young companies to have big improvements in revenue every year but operate at a steep loss. This happens when a company invests aggressively to lay the groundwork for its future—hiring more sales staff, investing to develop quality products and services to capture customers, building infrastructure, building supply chains and distribution networks, etc.
If investors understand the company’s strategy and vision and believe that it will eventually reach an inflection point to become sustainably and increasingly profitable, then the stock will rise even if earnings are negative. Amazon (NSQD: AMZN) is a prime example.
However, the company needs to consistently show that it is executing its strategy and keep investors convinced that the best days are ahead. If for example revenue growth slows down and losses show no signs of abating, investors will start to doubt the story and begin to abandon ship.
If a mature company experiences declining profit (or worse, losses), and management doesn’t offer convincing reasons why investors shouldn’t be concerned…well, it’s gonna be bad for the stock.
Thus, investors have different expectations for companies in different stages of their life cycles.
Investors Look for Different Things
The stock of a young company that is profitable but not really generating much revenue growth won’t likely do as well as a stock of another young company that is unprofitable but increasing revenue at a fast pace. After all, there really isn’t much upside for the first company. For profit growth to be sustainable, revenue must increase too. You can only boost earnings so much by cutting costs.
No company can grow at a breakneck pace forever. Sooner or later, growth has to slow down to a sustainable level. That’s quite alright. It’s just the way things are.
But an established company that’s reached the mature phase of its life cycle needs to be profitable. If such a company has already gathered the low-lying fruit such that there isn’t much visible growth runway left, investors will expect it to begin to pay shareholders a dividend and repurchasing shares (as opposed to reinvesting everything back into the company for growth).
Take note, investors shouldn’t take earnings figures at full face value. Investors should also study a company’s cash flow statements. If cash flow trends match up pretty well with earnings trends, then that’s support that the income statement does a good job of reflecting economic reality.
However, if earnings growth consistently isn’t matched by cash flow growth, there’s a chance that management may be using accounting leeway to massage earnings numbers.
An analyst with a sharp eye for spotting these kinds of financial shenanigans is my colleague, Jim Pearce.
Jim is the chief investment strategist of our flagship publication, Personal Finance. He has developed analytical tools that help him unearth the crucial data that the rest of the investment herd misses.
Jim deploys these sophisticated methodologies in his new publication, Personal Finance Pro. Want to learn more about his next profitable trades? Click here for details.