Three Important Considerations for Investors when Determining Revenue Growth

Revenue growth has a critical role in driving earnings growth for companies, which is indispensable for investment valuation. However, not all sales are equal, with companies having vastly different geographic or demographic strategies to drive future revenue. Additionally, companies can efficiently generate new sales by supporting sales of their current products or by working against their strengths resulting in less efficient or declining revenue. Below, we discuss our strategies to assess the type and quality of revenue growth with examples when we analyze companies.

• Companies target new customers in different parts of the world, demographics or additional sales to the same customer base
• The company’s industry and their internal competitive advantages will help determine the profitability of these new sales
• Successful revenue growth depends on The ability of the company to generate new sales that supports their current advantages

#1 Strategies to Grow Revenue:

Companies typically generate revenue from the sales of their goods and services. This is the first reported segment of the income statement and is often referred to as the top line. Revenue is usually a positive number, though returns or rebates can exceed product sales during a short period of time.

Revenue is one of the most important metrics to assess when analyzing potential stock investments. Increasing sales of products or services can bring more money into the income statement, which can hopefully translate into higher earnings and thus higher returns for investors. Typically, revenue growth can be accomplished via some combination of strategies below:

1) Expansion of business operations to new regions of the world: This strategy involves selling a company’s current products or services in parts of the world where they currently have limited or no operations. One major advantage of geographical expansion is that it can open the company up to vast amounts of new customers. Examples of this strategy include T. Rowe Price (NASDAQ: TROW), which we recently discussed is targeting new international investors to their funds to ultimately grow their revenue.

2) Targeting new demographics: Instead of trying to expand geographically, companies can elect to try to sell to new groups of people in the same region. This has the advantage of allowing companies to increase the total number of customers without hopefully needing to develop new supply chains or be exposed to new foreign regulations. Coca-Cola Company (NYSE: KO) is one such example of this, where they expanded their products to include low sugar drinks to appeal to a larger base of customers.

3) Developing new products or services for the same customer base: A company can also target the same customers with new products or services to increase total revenue. This strategy can be broken down into market cannibalization or market synergy.

a. In market cannibalization, new products provided by the company are meant to attract customers from competitors but also displaces sales of their current products. An example includes when a company develops a new line of smart phones. The new model might attract new sales, but it will also likely hurt sales of the previous phone model.

b. In market synergy, the new sales will ideally be made in additional to the old sales. Bundles and memberships are an excellent example of market synergy. For instance, we previously discussed how Comcast offers TV and internet bundles to customers that can actually encourage customers to keep both services. We also discussed how Best Buy offers membership services which generates new revenue and support sales of their products.

4) Raising product/services price: Many people believe that if a company wants to make more money, they can simply raise how much they charge people. However, this can often have limited effectiveness in the long run. Competitors will often steal customers from a company with prices that are too high. This can result in loss of customers which can actually decrease revenues for the company. Companies typically determine prices based on supply and demand for their product/service. However, this can be disrupted when a company gains a competitive advantage (see more in the next section).

Although this is not a comprehensive list, I believe it covers many of the common revenue growth strategies. It is also common for companies to combine these strategies to drive the most meaningful sales growth.

#2 What Makes Companies Profitable:

After a company generates their sales (revenue), the next line in the income statement is the cost of revenue. All products and service cost money to provide, and the percent of money left over after accounting for cost of revenue is known as gross profit margin.

One of the largest impacts on gross profit margin is the industry where the company operates. Certain industries will support much higher gross profit margins than others. For instance, we discussed that the high profitability of cigarette manufactures Altria and British American Tobacco is due to how much cigarettes sell for and how cheap they are to produce. Not all companies enjoy this advantage though, with many retailers having less than half this gross profit margin.

Not only does gross profit margin vary widely by industry, but also within different companies within the same industry. For instance, below we have some financial data provided from soft drink companies in North America:

What immediately jumps out is how different the gross profitability differs for these companies. For instance, Coca-Cola has over double the gross profit margin of Jones Soda Co. So why do some companies support higher margins than others? Why are some industries more profitable than others?

I believe that the reason profitability changes so much is due to competitive advantages of the company or industry. Competitive advantages, often referred to as moats, allow companies to charge premiums for their products or services. I generally separate gross profit margin into the following two segments:

1) Internal competitive advantage: This typically involves the company developing some internal innovation that has allowed them to be more competitive. This could include having patents, trademarks or trade secrets that prevents competitors from duplicating their products/services. It can also involve requiring large infrastructure or capital requirements that make it difficult for new competitors to enter the business. Finally, the company can also have developed a brand name, in which customers are loyal and willing to pay extra for that particular brand.

2) External competitive advantages: Competitive advantages can also be granted due to external factors, including local rules and regulations. Governments may enact new regulations that effectively create barriers to entry for new companies. Regulated utilities are an excellent example of external advantages, as they are protected against competitors and have a monopoly over customers in that region. In exchange for the effective monopoly utilities enjoy, governments have some control over fees and rate increases.

Circling back to the soda companies mentioned above, part of the reason the Coca-Cola company and PepsiCo have such an advantage is due to their brand name. Both companies make easily recognizable products that customers are willing to pay premium prices. Fun fact: Coca-Cola also has a long standing strategic partnership with McDonalds which has also helped their brand expand internationally.

#3 Potential Investing Questions when Evaluation Revenue Growth:

Whenever I consider investing in a company’s stock, I always try to assess how the company is planning to generate future revenue. The long-term health of the company will be dependent on how successful they are in generating this future revenue. Some of the questions I ask when trying to evaluate a company are below:

1) What is the company’s plan to generate future sales?

The first part of this involves understanding the strategy to drive more sales. The second part involves understanding the company’s sale goals and timeline.

2) Are the new sales synergistic or competitive with their current products or services? Understanding how the new proposed sales will affect current sales is critical. Ultimately, the amount of future revenue will be the difference between new sales and loss of old sales.

3) Will the company maintain their competitive edge for this new product or service?

The competitive advantages the company currently have should also extend to the new sales.

It is important to realize that there can be significant amount of risk when a company pursues a new revenue strategy. The company will likely expend significant time and money to develop a new product or service. It is also possible that the company may acquire another company to grow sales, potentially at great expense.

Although this cost is almost always guaranteed, the results can be very variable. Both AT&T and Altria had multibillion-dollar acquisitions that increased debt but had disappointing revenue growth. In fact, it is estimated that between 70% to 90% of mergers and acquisitions fail. This is why I believe that it is important to always assess how feasible their plan is and to develop my own hopefully conservative estimates.

Summarizing Thoughts:

Future revenue has an important role in the long-term health of companies. There are a variety of strategies companies can take to grow revenue including expanding globally, to new demographics or developing new products/services. A company’s competitive advantage will support higher profitability, and should ideally extend to future revenues. Finally, I believe that assessing the ability of a company to efficiently execute their revenue strategy is critical for long-term investing.

Disclaimer:

I currently own stocks mentioned in this article including Altria, Best Buy, British American Tobacco, Comcast and T. Rowe Price stock at the time of writing this post. I am not a financial advisor and I am not providing financial advice. I am sharing my thoughts and processes of selecting stocks for my personal portfolio for fun and entertainment purposes only.

All information provided here is on a “best of my knowledge” basis and may be incorrect. All estimates and models are guesses and may not be accurate. Stocks mentioned here may have additional risks not covered in the post.

Investing in the stock market comes with serious risk of losing money, please consult a professional financial advisor and do due diligence before investing.