The Importance of Revenue Growth In Selecting Winning Investments
This is a guest post from JC, who writes about dividend investing on Passive Income Pursuit. JC has been a dividend growth investor since 2011 focusing exclusively on dividend paying stocks for his long term portfolios.
Over the last couple weeks I’ve been writing about how companies grow and why it’s so important to see how the growth is coming because not all growth is created equal. Today I wanted to give an example of the differences that can arise if you just look at the numbers as reported instead of digging into them yourself. But first a quick recap.
Revenue growth is one of my favorite metrics to look at for a company. I don’t have any numbers to back up my claim, but I think you’ll all agree that a growing revenue stream leads to rising profits which leads to my personal favorite, a sustainably increasing dividend. It’s pretty safe to say that you won’t find many companies that have a lengthy dividend growth streak that haven’t also grown their revenue. That’s why I feel it’s so important to monitor the top line and how it’s growing.
Companies have 4 ways to organically grow the top line and another way to manufacture that growth.
Selecting Winning Investments – The 4 organic growth avenues are:
- Price Increases – Real
- Volume Growth – Real
- Market Share – Real
- New Products – Real
The truly excellent companies are able to capitalize on all 4 of these sources and take advantage of opportunities as they come. Whenever you find a company that is able to increase prices while also growing their volumes you ears should perk up.
Sometimes companies reach the point where they can’t make any significant increases on the first 3 organic growth streams which puts them in the position of needing to expand to another product or brand. That’s when they are faced with the decision of doing everything in house and developing something new or to use the 5th way to grow revenue: manufacture it.
No I don’t mean manufacture as in build a new plant, but rather manufacture the revenue growth by looking for an acquisition target (quasi-engineered). When acquisitions are done right they can provide higher revenue as well as more profits due to the reduction of duplicate costs.
For more information on the 5 ways companies can grow check out this post.
Earnings per share should also grow over time if a company is able to consistently grow its revenue. Companies generally have 3 ways to grow their earnings per share.
- Increase Revenue – Real
- Decrease Costs – Quasi-Engineered
- Decrease Shares Outstanding – Real & Engineered
If a company does all 3 of these together then earnings per share will show a nice upward growth trend. Combine that with a culture of rewarding owners with higher dividends and you have a great dividend growth investment candidate.
I’ve already covered revenue growth so let’s move on to decreasing costs.
Decreasing costs is essentially a way that companies can reach higher productivity. As a quick example if Company A and Company B make competing products in the lucrative widget industry of widget making. Company A can make 1,000 widgets at a cost of $1,000,000 and Company B can make 1,000 widgets at a cost of $900,000. If the sale price is the same and everything else being equal, then Company B would make a more attractive investment since they can generate most product for less cost.
However, I consider decreasing costs as quasi-engineered growth since there’s a natural limit to how much costs can be reduced before hurting the quality of the product or the productivity of the company.
I think we all agree that decreasing shares outstanding is a good thing for companies to do since it increases the ownership stake of the remaining shareholders. However, when it comes to how companies get their growth this is the most engineered form and something that needs to be watched closely.
Selecting Winning Investments – Let Me Tell You A Story
Every company has a story to tell and they tell that story through their financial statements and press releases.
Press releases are like the trailer for a new movie. You get the general idea of how things are going and some highlights of the big scenes, but much of the details are missing. It’s not until you go and see the full length version, the financial statements, that you find out all of the details that go into that story.
The numbers that a company reports tell a story and you need to make sure you’re ignoring the bias from management. Executives of a company don’t want to paint a negative picture of the company so they’ll only highlight the numbers that shows them in a positive light.
Even though it takes more time than just looking at the numbers as reported, this is one of the most crucial steps in determining how a company is generating its growth. Essentially is the growth for real or is it engineered. You need to look beyond the headlines to figure this out.
Let’s take a look at one company’s numbers and the wildly different stories they tell.
Revenue per share hasn’t grown every year; however, the long term trend is for rising values. There’s a nice trend of growing values on a per share basis. However, as I mentioned earlier it’s important to compare the per share growth to the gross values of the same metrics to make sure that share reduction isn’t generating the bulk of the growth.
Let’s look at the gross values of revenue to see if there’s a different story to be told.
The gross revenues tell a completely different story from the per share narrative. From 2006 to 2015 the gross revenues have decreased by over 10% while revenue per share has increased by over 40%.
I think it’s pretty clear that we have different story lines being told to us. In one case the company has shrunk by over 10% over the last 10 years and in the other case the company is showing an improvement by over 40%. So which one do you believe?
I personally don’t look at the per share values to determine if there’s real growth going on because it gets skewed too much by share count reduction. The gross revenues show the actual growth of the company, or in this case decline of the company. If you are wondering, the company we looked at above of course is International Business Machines (IBM).
Selecting Winning Investments – Conclusion
This doesn’t necessarily cross this company off the list because all we’ve looked at is two versions of the same metric: revenue and revenue per share. This is just one piece of the puzzle and there’s plenty of other things to take into consideration before making an investment decision.
When you look at other pieces of information you get even more stories told to you. This company is transitioning into different product/service lines which shows up elsewhere in the financial statements. Despite a 10% decline in revenue they’ve actually seen a 20% and 39% increase in the gross free cash flow and net income, respectively. That speaks to the improvement in margins and efficiency of a dollar through the company which is always a good.
Don’t get lured into making investment decisions based on the headline numbers that a company reports because sometimes they can tell very different versions of the same story. Always put in the time to figure out the story that’s actually being told, rather than the story being told to you.
Selecting Winning Investments – DGI Full Disclosure: I am long IBM