Investing Theory

Rising Revenues: Transformative Power of Growth

October 12, 2023

The most enticing aspect for a co-owner of a company (an investor owning shares) is the revenues generated through the company’s assets. However, it is essential to consider various factors when evaluating this single metric.

First of all, in today’s world, revenues are actually the most important financial metric. Period. No revenues – no profits. No profits – no dividends. Everything starts with revenues.

Revenues are at the very top of the ladder. In the absence of growing revenues, a company can, of course, increase its profits to some extent, but this is treading on thin ice. Net profits can be increased in two ways: by selling more and more goods or services or… by cutting costs.

Long Term Perspective

The first way allows for virtually unlimited expansion and development, while the second one will work only up to a certain point. After all, there is a limit to how much one can cut costs on marketing, advertising, or administration. At some point, excessive cost-cutting begins to negatively affect sales, which only lowers revenues generated in subsequent periods.

In the stock market world, from an investor’s perspective, it is therefore extremely important that a company’s revenues consistently, stably, and predictably grow. Only such a situation will justify a long-term increase in the stock price. Without increasing revenues, subsequent investors will have no reason to pay more and more for the shares of a given company. That’s all there is to it.

Unleashing the Power of Business Growth

Imagine that we are buying shares of company XYZ today for 300 USD per share. The company XYZ currently generates 200 USD of revenue per share. Without much thought, it can be said that the price per share in this case seems fair, as the investor pays 300 USD in exchange for 200 USD of revenue that will accrue to them from the sales achieved by the company after the first year of investment (for now, let’s skip the issue of the valuation method). The company is neither overvalued nor undervalued.

Now let’s move two years ahead in time and imagine that the company then generates 400 USD of revenue per share. How much should its share cost on the stock exchange, assuming that 300 USD for 200 USD of revenue was a fair price?

If investors, understood as the entire market, decided two years earlier that they could pay 3 USD in the share price for 2 USD of revenue from that share, then in a situation where the revenue doubled, they would likely be willing to pay twice as much for shares. As a result, the status quo will be somewhat maintained, as shares will be valued in the same way.

Two years earlier, the price-to-revenue ratio was 1.5 (300 : 200), and today… it is also 1.5 (600 : 400). We still pay 3 USD in the share price for 2 USD of revenue here, or alternatively – we pay 1.5 USD in the share price for 1 USD of revenue, or yet another way – our 1 USD investment will be fully covered by the revenue earned in one and a half years.

What conclusions can be drawn from this? Well, there are a few.

Why do We Need Revenues?

First and foremost, a company’s revenues must constantly grow so that investors have a good reason to pay more and more for its shares on the stock exchange.

Imagine an alternative future in which the company’s revenues did not grow from 200 to 400 USD but fell to 100 USD. In this situation, to maintain the price-to-revenue ratio per share (at 1.5), its share price would have to fall from 300 to 150 USD.

The problem is that the stock market is not an arithmetic class, so the stock price rarely behaves exactly as it should ­– but fortunately, it very often behaves more or less as it should in the long run. To put this argument in a simple catchphrase: if a company generates more and more revenue, its share price will also rise.

Such a phenomenon is quite logical. When a farmer wants to buy a hen that lays golden eggs, he will be willing to pay more money for a hen that lays five golden eggs a week than for a hen that lays three golden eggs.

The paradox of golden egg: better price for a hen issue.

This happens because, when determining the transaction price, the next buyer will consider what they currently get in return for it. In this case, they will convert each dollar invested in the hen into golden eggs that the hen produces.

This law applies to everyday life in relation to any other object. If we want to buy a car that accelerates to 250 km/h, we have to pay more for it than for one that accelerates to only 150 km/h. Airlines will charge a higher price for a ticket from New York to Beijing than from New York to Chicago. A ring with three diamonds will be more expensive than a ring with one diamond. The more we get in return, the higher the price. The same goes for stocks on the stock market.

That is why it is extremely important to pay attention not only to whether a company generates significant revenues compared to the current share price, but also to whether the revenue trend is growing, and whether forecasts speak of further growth.

We Need More (and More) Sales

A company can generate decent revenues, and its share price can be fair, but if revenues are not growing regularly, what reason will another investor have to buy these shares from us at a higher price than the day we bought them?

Another person will want to pay more for shares only when they get more in return than we got at the time of purchase. What an investor can get from a company besides an increase in the value of its assets is the amount of revenue the company generates with its assets.

An increase in asset value is well-received, but it is not necessary to generate ever-higher revenues. Efficiency also matters.

Compare what could be achieved in 1960 using a 50,000 USD computer to what can be achieved in 2023using a 1,500 USD computer. The old “computers” of astronomical value that controlled the first Apollo spacecraft’s flight to the Moon had less computing power than today’s cheapest iPhone. The value of assets in itself does not mean anything unless we consider how much revenue is generated using them.

Summing Up…

Many people repeat like a mantra that revenue is not profit and that what really matters is not how much a company sells, but how much net profit it generates after deducting all costs and paying taxes. But is that really the case?

If your still hungry for more – be sure to read about it more specifically in the Unmasking the Surprising Irrelevance of Profits in Today’s World text!

Start your free trial

And save 97% time spent on stock analysis!

Similar posts

Start your 7-day free trial

Automate your research and quickly find undervalued stocks.
Get Started →
No credit card required
Cancel anytime