The value of all common equities is closely tied to the earnings power of their issuers. To assess the value of a stock, an understanding of the issuer's earnings potential in the next quarter, year or even decade is required. In turn, to properly understand earnings potential, investors must evaluate the source for all company earnings and cash flow: revenue.
Therefore, one of the most important elements in valuing a stock is projecting the top line of the issuing company. While earnings growth—which is a focus area for most equity investors—has many different components, revenue growth is often a prime factor. In this article we will address the fundamentals of understanding and projecting the top line.
Pay Close Attention to Revenue
The first step in virtually every company analysis project is to carefully examine what the company does to generate revenue. The best places to look for answers include the company's financial filings (10-K and 10-Q reports), recent company investor presentations, company websites and a wide variety of other informational sources. At this stage, investors should focus on understanding what the company does, not how well it does it. Investors should also try to understand differences and similarities between key business segments if the company has more than one.
Secondly, it is a good idea to develop a perspective based on historical trends. As a starting point, it is useful to compile a table of quarterly revenue over several recent years in a spreadsheet. The more detail the better—if a company has more than one business segment, it is helpful to break out each revenue component in the table. Once the data is in the table, you can measure year-over-year and sequential (quarter to quarter) percentage growth in revenue for each time period. Analysts also often calculate compound annual growth rates over periods of several years to analyze growth trends over longer periods of time.
Is the Company Positioned for Future Growth?
Once the historical trends have been identified and delineated, the next step is to ask some "why?" questions. If revenue growth was much higher in certain periods than others, analysts need to understand why that happened. Did the introduction of a new product result in a period of very high growth? Did a large acquisition or new customer add a significant new revenue source? Did softness in the company's end-user market cause revenue to weaken? Asking questions such as these, which can often be answered by carefully reading the MD&A section in financial filings, will aid in understanding the company's business model and will set the stage for making well educated assumptions for the future.
A good basis for the current year's revenue projection is the immediate historic trend. Reading recent filings can help investors to understand factors that might be affecting top-line performance today. If a company has been growing revenue at a 10% annual rate in the past few quarters it might be a stretch to assume revenue can grow at a 20% annual rate in the current year unless some fundamental change in the business has occurred that will drive this faster growth. The key is to understand what those business drivers are in order to gain comfort with projecting the top line.
Once we understand what the company does for a living and what the historical revenue trend looks like, it is important to analyze the present business situation and management's expectations for the future. Most public company management groups give some form of financial guidance or expectations for future revenue and earnings potential. This is often a good fundamental basis for near-term revenue projections. As a matter of due diligence it is wise to consider how good guidance was in the past. It is helpful to examine historical guidance relative to the actual historical numbers in order to determine how well management understands its business and how much visibility management has for the immediate future.
Look at the Target Market
The top line of any company is primarily driven by what's going on in its end-user markets. If a company makes cellular telephones, then the end-user market is made up of cellphone subscribers. An investor should consider the worldwide subscriber growth rates and the cellphone replacement life cycle to assess the revenue growth potential of the industry. If the subject company is a mortgage lender, one might want to examine the trends in unsold home inventory, interest rate trends and overall consumer health in the regions in which the lender operates. Once you develop an understanding of growth potential in end-user markets—both in the next couple of quarters as well as several years in the future—you can better understand the revenue growth potential at the company level.
Analyzing how a company's top line has changed over time relative to the end user market can generate important clues about the company's competitive position, which is also a key factor in making revenue growth assumptions. If a company's top line has been organically growing faster, than its end-user markets, then the company might be gaining market share. The opposite could also be true. Either way, making such a comparison can highlight problem areas, or areas that require more analysis. If you believe that the subject company will maintain its competitive position over time, then you might expect the company's top-line organic growth rate to be the same as the end-user market as a whole. If industry competition is increasing then the company's market share could also decrease over time, which would likely cause the company's top-line growth rate to be slower than that of the end user market and other companies in the industry.
Consider the Competitive Environment
A changing competitive environment is also one of the factors that can affect pricing in end-user markets. Analysts often examine how the average selling prices (ASPs) of a company's products change over time in assessing top-line growth. The idea is to assess how much of top line growth has come from—or might be expected to come from—pricing changes versus changes in quantity demanded of products in the open market. Increasing industry competition can drive ASPs down and vice versa. In addition, products with inelastic demand characteristics (quantity demanded changes by a relatively small amount relative to pricing changes) are more likely to correlate to pricing-related revenue changes than volume-related revenue changes relative to products with elastic demand characteristics. Understanding elasticity can help in projecting future industry revenue potential and, therefore, the revenue projection for the subject company.
The Bottom Line
Well-formed top-line projections come from working on a few key aspects of company analysis. First, historic financial analysis can help build expectations for revenue growth assumptions, taking into consideration recent events that might cause revenue growth to diverge from recent trends. Second, it is important to examine the characteristics of growth in end-user markets, because these are the source of all company revenue in the first place. Thirdly, examining the competitive environment and the demand characteristics for the company's products can help you understand why the revenue growth rate might be faster or slower than industry growth as a whole. Start with understanding what the company does for a living and then assess how that factor might change in the future.