CONTRIBUTOR

What matters most at a company? Revenue growth

Nancy Tengler
Special for The Republic | azcentral.com
Revenue growth matters a great deal more than reported earnings growth, because revenue is a fact. Earnings are often produced through accounting gimmicks.

Our real-time investing laboratory is providing the opportunity to learn many valuable lessons. Today’s? Revenue growth matters a great deal more than reported earnings growth, because revenue is a fact. Earnings are often produced through accounting gimmicks.

Third-quarter 2015 earnings, as disappointing as they are, have exceeded analyst estimates in 75 percent of those companies who have reported. Many reasons are behind this achievement, but the most important is that, when push comes to shove, company management teams can improve earnings by deferring expenses, writing off bad investments and restructuring or buying back stock with debt, to name a few strategies. In other words, earnings are malleable. Revenue, on the other hand, is not.

Top-line growth tells investors a truer story about a company’s future, which is why companies that beat expectations on the top line are being rewarded much more than companies who beat on the bottom line alone. Barron’s reviewed a list of revenue and earnings overachievers this past weekend, and the stocks that exceeded sales expectations realized a price rise of 1.5 to four times the percentage of the revenue beat.

Take, for example, Microsoft. In 2003, I wrote a book titled “New Era Value Investing” in which I discussed using sales as a valuation metric to identify cheap stocks through a tool called the Relative-Price-to-Sales Ratio (RPSR). This metric measures how much an investor is paying for a company’s sales compared with the stock’s own history. At the time, I published the book, MSFT had entered the buy range based on its own RPSR historical pattern, although revenue growth was unspectacular. From that point MSFT generated an annualized return of 6.3 percent for the next 10 years, slightly lagging the market.

Recently, revenue growth has accelerated — in the third quarter, MSFT revenue exceeded expectations by 5.0 percent — and the stock quickly appreciated 10 percent in response. From 2013 through the end of last month (since revenue growth improved) the stock is up 30.6 percent annually, compared with 16.7 percent for the S&P 500 as a whole.

Revenue provides investors with visibility. When the top line expands, so does the stock price.

But as regular readers know, I am also a big fan of dividends, because dividends are set by management teams and boards of directors and provide insight into understanding future, real earnings. The seasoned pros set the dividend as a portion of what they believe to be sustainable earnings. They don’t want to cut the dividend, so they are prudent, because the payout comes out of real earnings, not accounting gimmicks.

Using our MSFT example, we see strong double-digit dividend growth over the trailing three and five years. This strong dividend growth signals management’s optimism about MSFT’s future earnings, and the robust top-line growth confirms the view. Microsoft is an interesting specimen to watch and learn from in the coming years.

Nancy Tengler spent two decades as is a professional investor. She is an author, financial-news commentator and university professor. Reach Tengler at nancy.tengler@cox.net.