When listening to the financial media around earnings season in particular there is a lot of talk about companies’ top line and bottom line. The top line refers to the revenue as it is at the top of the income statement, and the bottom line refers to net income which is at the bottom of the statement.

While ignoring the financial media a prudent investor must still always pay attention to the revenue. If earnings are increasing while revenues stay flat or decrease this is a warning signal. It means the company is only increasing earnings by reducing expenses and not by increasing revenue. There is only so much a company can cut expenses and at a certain point earnings will stagnate or decrease unless revenue rises.

When evaluating the revenue it is important to know what drives the revenue. This will be different depending on the industry. Let’s look at one example below (this article will seem relatively elementary for more advanced investors but is mostly aimed for new investors):

Below is revenue for Wisdom Tree ticker (WSDT.PK) from  WisdomTree.com . I did not use edgar.com since the stock is traded over the counter. Stock information can be found on  pinksheets.com, however the company’s press release from their website contained far more information.

For The Three Months Ended

September 30th, 2010

Revenues (in thousands) $10,058.

The first question I ask myself is how did they earn the ~$10m in revenue?

Wisdom Tree is an asset manager, which issues exchange traded funds (ETFs) and charges a fee. For example I buy $10,000 of WisdomTree’s Earnings Fund ticker (EPS). The fund has an expense ratio of 0.28%. If the fund goes up 10% I earning 10,000*10%-$28 giving me a total of $10,972. The $28 is the money Wisdom Tree earns. For simplicity sake I assumed that fees were deducted at the end of the year and not on a quarterly or semi-annual basis.

If you go to the bottom of the statement you see that average assets for the period was $7billion and the average expense ratio was 0.56%. If you multiply the two numbers you get ~$40m. This is how much they would have earned for the year so you divide by four and get ~$10m which is the revenue for the third quarter.

The most important aspect to look at when evaluating an asset manager like wisdom tree is assets under management or AUM (for other industries there will be other important factors which I plan to discuss in a future article). The most crucial thing when looking at AUM and I can not stress this enough is the two factors that drive the fund flow; market appreciation, and inflows.

For WisdomTree below is the latest data:

~6.2b beginning of period AUM

~$1.2b inflows

~$860m market appreciation.

End of period AUM ~$8.3b. When evaluating beginning vs. ending AUM you must look at what is driving it. In this example it was both the ETFs going up and investors putting more money into ETFs. However, if you just looked at beginning AUM versus ending AUM the numbers could be decieving.

For example let us look at the latest press release from Calamos Investments. Here is a direct quote : “Assets under management as of September 30, 2010 were $32.6 billion, representing an increase of $2.7 billion, or 9%, from the previous quarter end. That number sounds pretty good since the more assets they bring in the more money they make, right? Well read the next line “The increase consisted of $3.1 billion in market appreciation partially offset by net redemptions of $0.4 billion.”

The company’s entire gain in AUM was due to market appreciation. This is because the stock market and high yield bonds did very well during the third quarter and Calamos mostly invests in stocks and high yield bonds. However, investors were pulling money out of the fund during the period.

An asset manager can not be successful if the company can not get people to invest in their funds. One quarter does not make or break a company but analyzing several quarters (and years) of data is important. It also is important that a company’s AUM is not due to the stock market rising. If the stock market rises almost any asset manager with a decent size allocation will make money.

To conclude when looking at an asset manager see where the revenue is coming from. For WisdomTree it is almost from entirely ETF fees and is quite simple to calculate. For some asset managers it will come from a variety of sources including money market funds, close ended funds, separately managed accounts just to name a few. It is important that the company is able to attract and retain investors, and their AUM increase should be due to money coming in, and not due to market appreciation. Even a monkey running a company could increase revenue/AUM if all asset classes are going up.

Disclosure: I am long CLMS. I have no other position in any other companies or ETFs mentioned.