Relationship between Revenues and Net Earnings

In any type of analysis, the tests that reveal the most involve a study of relationships between accounts. On the income statement, the most important relationship is that between revenues and net earnings.

As a general observation, you should expect to see a company's revenues increase over time. This is achieved through one of five methods:

1. Increased market share. If a corporation is competing effectively, it will be able to take market share away from its competitors. It is interesting to observe how competing corporations vie for first, second, or third place and how revenues change over time. In retail, for example, any long-term observer has noted that Sears and K-Mart have been losing sales, forced to close stores, and reporting less and less retail square footage each year. In comparison, competitors Wal-Mart and Target have been expanding at the same time, dominating their markets and reporting ever-higher retail square feet. From the analytical point of view, it is sensible to observe these comparative trends; figure out what corporations are doing to compete, and how effectively they accomplish their goals; and what likely future trends should be expected.

2. Increased market size. Some markets grow, whereas others do not. For example, in the early 1990s there was virtually no market for Internet-based book sales or auctions. By the end of the decade, these markets had exploded. Today, most people have home computers and Internet access and a large amount of transactions take place online. This is a recent example of an expanding market. It occurs elsewhere; when auto manufacturing began more than 100 years ago, there were few useable roads or mechanics. A decade later, over 200 auto manufacturers competed for a rapidly expanding market of American consumers, demanding automobiles. Market observers know that new technology creates new markets.

3. Mergers and acquisitions. In the past, merger and acquisition activity was quite high. Markets have gone through phases of leveraged buyouts and the use of mergers to create favorable financial results. Aside from these strategic reasons for mergers, there is also a competitive reason. Corporations may buy smaller competitors to eliminate them as well as to expand their own market share. A well-timed and carefully structured acquisition or merger can help improve overall financial performance and justify the cost of purchasing another company. Even so, there are only so many competitors worthy of buying; so if a corporation is undergoing a large volume of mergers and acquisitions, it should raise your suspicions. Also, in attempting to estimate long-term revenues based on current trends, remember that acquisition-based revenue growth is not going to recur every year.

4. Product line diversification. Just as investors are encouraged to diversify their capital, corporations also need to diversify their product or service lines, for several reasons. First, diversification helps protect corporate cash flow against cyclical change. Second, it opens up new markets and helps continue healthy revenues and earnings trends. Third, diversification may become necessary when a product becomes obsolete. For example, Altria Corporation has expanded away from its previously dominant domestic tobacco sales as U.S. opposition to smoking has had an effect on sales. Altria's international tobacco sales and food division revenues are gradually replacing cigarette sales in the United States.

5. Geographic expansion. Corporations can open outlets overseas. The global economy is becoming more typical and less of an oddity today, compared to the past. Many corporations are already multinational in nature and international revenues represent major portions of overall revenues. While some industries are dominated by Asian corporations (notably in manufacturing and related industries), there remain many others such as retail, energy, and IT (information technology), that continue to expand overseas rapidly. International markets present potentially high revenues growth for many corporations. For investors, identifying industries likely to benefit from increased international activity, and then finding the corporations likely to benefit the most, is a sound way to choose companies for long-term expansion.

All of these sources for higher revenues are finite. No growth can continue forever without slowing down and eventually ceasing. This is a reality in any analysis of long-term revenues and earnings. So even in the most successful instance, and even when corporations employ all of the methods listed above to create and continue revenue expansion, there is a natural limit. Successful companies evolve with changing times, to take advantage of ever-growing markets. History shows this to be the case.

IBM was originally founded as a typewriter repair company. For many years IBM dominated repair and manufacturing of manual and electric typewriters. When it became apparent that the home computer would soon replace typewriters, IBM quickly reinvented its primary revenues model, replacing typewriter manufacturing with a new product line: computer hardware.

Similar examples can be found in virtually all industries. Prudential used to be known primarily for its whole life insurance business, as well as other insurance products. Today, Prudential is one of the major financial advisory concerns, with services ranging from investment banking to research, financial planning, and other related services in addition to insurance. Today, many large banks also are involved in financial services and investments as related service areas.

In retail many interesting trends are underway. The standalone franchises of the past are now found in growing numbers in larger stores or opened in combination with other franchises. Starbucks Coffee has hundreds of stores, but new franchises open up as often as not in grocery stores or in combination with other food franchises. Food courts in malls, highway access areas, and even downtown centers are seeing more and more combination Taco Bell and Burger King outlets in single buildings and fast food attached to service station convenience stores. These combinations cut overhead while exposing the stores to good volumes of traffic.

These marketing trends are examples of emerging strategic planning, taking advantage of high-volume traffic areas with reduced or low overhead setup. Even so, revenues are only one half of the revenues-earnings equation. While there are many ways to increase revenues over time, earnings may grow, but have greater limitations.

Each industry tends to experience a relatively narrow range of earnings, normally expressed as a percentage of revenues. So if a likely range of earnings is going to be between 12 and 15 percent of revenues, it is not rational to anticipate ever-expanding earnings growth beyond the 15 percent range.

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