I think there is a big need for hands-on investing education, especially in the microcap space. Most people are able to grasp the qualitative aspect of investing, but few are really able to perform the financial analysis due diligence that should be completed before making an investment. Aside from managing money, I’ve also created The Invest Like the Street Program which gives adults and college students hands-on investing education, beyond the useless theory they teach you in skill.

I’m going to start a series of post that teaches our readers different aspects of financial analysis in hopes of helping everyone become a better investor.

If you are still new to investing, I’d highly recommend reading the Intelligent Investor and The Most Important Thing which were both written by investing legends.

If you’re ready to get into the numbers, the first post in this education series will be on identifying different types of revenue.

Let’s get started.

Why is it important to understand different types of revenue?

When analyzing different micro-caps, you’ll often see some pretty sky-high revenue growth numbers. But, sometimes there’s more to the story. Is the company really growing as fast as you think?

Let’s take a look at the different types of revenues.

Financial AnalysisFinancial Analysis

There are two primary ways for a company to grow its revenue:

Organic: This is the type of revenue every investor really wants to see. This is pure revenue growth thanks to a company’s ability to sell its products or services.

Acquisitions: When a company wants to supplement its organic growth or is struggling to grow organically, they can acquire a company and essentially acquire its revenues. When done right, it works quite well, but sometimes growth from acquisitions can mask a company’s ability to grow organically.

How Acquisitions Can Hide A Company’s Growth Struggles

Let’s look at an example:

Financial Analysis

At a first glance it looks like this companies growth really started to pick up in Q3 and Q4!

But was there something else going on? An acquisition perhaps?

Sure enough, if you were to look deeper, you’d see the company made an acquisition, and that started to contribute to revenue growth.

Financial Analysis

As we can see, if you ‘backed out’ the revenue from the acquisition, the company really grew at 10% and 23% in Q3 and Q4 versus the 61% and 72% we previously thought.

Let’s talk about the two types of growth that can result from acquisitions:

Pure Acquired Revenue: This is simply the revenue acquired from a company

Revenue Synergies: This is additional revenue that can directly be attributed to an acquisition. For example, let’s say Company A acquires Company B. Company B happens to have close connections with a different company, Company C. Because of that, Company A was able to sell additional products or services to Company C that it wouldn’t have been able to without the acquisition.

So what if the company in our example had growth from revenue synergies instead? Let’s say we asked the company, and this is what we found out:

Financial Analysis

So much for those big growth numbers.

As you can see, pretty much all of their growth can be attributed to acquisitions, and organic growth remains pretty weak.

How to Analyze Organic Growth

Let’s go back to organic growth for a second. There’s three ways you can view a company’s organic revenue:

Recurring: This is the kind of revenue you’ll see a lot of types from SaaS (software-as-a-service) companies where the revenue is predictable because they company’s customers pay a predictable, consistent fee every month, quarter or year. This is the kind of revenue that makes your life easy as an analyst.

Lumpy: This is the most common type of revenue you’ll see. It’s essentially sporadic revenue from sales of products or services that isn’t exactly predictable. Pretty much every company has this type of revenue.

One-Time: This is the type of revenue that is expected to only happen once, and can skew sales upward. For example, set-up fees, one time sales to customers, etc.

Let’s look at an example:

Financial Analysis

What do we see here?

  • The company’s recurring revenue was pretty consistent until about Q3 when it likely added new customers.
  • The $50k in revenue in Q3 was likely associated with start up costs for that customer.

In conclusion:

  1. Be careful when a company posts strong looking growth numbers.
  2. Always try and understand what’s driving the revenue growth.
  3. While you’re at it, make sure you understand what types of revenue are driving the company, whether its purely recurring and lumpy, or if there are big one time revenue boosts that are skewing revenue.

Article by Why MicroCaps