Top Line Truths, Bottom Line Realities

A few months ago during ‘earnings’ season, the 30 companies that are a part of the Dow Jones Industrial Average shared with the public the status of their businesses. The results were spectacular; the market’s reaction was lackluster. The “analysts” were saying that the market wants to see GROWTH, not just growth in earnings, but growth in REVENUE. In essence, turning a healthy profit and even increasing dividends was not what the market was really looking for; and in doing so, the stock price of these companies would not fully appreciate. “That makes sense”, I said to myself. “You know because the market is forward looking and growth really determines the prices, just look at P/Es for example”, I said out loud and alone in my office. But I couldn’t leave the topic alone, I had to dig further.

I have been long on equities since June and just can’t help to feel a bit bullish on stocks right now. Don’t get me wrong, the economy, housing, jobs, and fiscal deficits are painfully ugly. I couldn’t help but think about how a business works, and in particular, how a balance sheet and income statement work. If a company is making a profit, and is not distributing 100% of it to its shareholders, then the rest is being added to Retained Earnings. If the retained earnings section of the balance sheet is growing, my portion of equity is also growing. I understand that fundamentally stocks need not only growth in profits, but in revenue too. In essence one wants a company in the growth phase and not in the mature/declining stage. The media has talked so much about the lack of top line/revenue growth that I decided to analyze the bottom line/net income instead. In a very simplistic manner, find the average net income of a company in the Dow Jones Industrial Average from 2007 through today. Note that the companies that make up the Dow have changed from 2007 to today. To find the value of 2010, I simply forecasted the firms’ statements from the first 2 quarters of data (net income is in billions).

-------------------------2007---------2008-------2009---------2010
Avg. Net Income : $9,054------$8,374-----$7,068------$8,676
Avg. Prof. Margin: 11.37%-----10.37%----11.25%-----11.90%

As one can see, the average net income of companies in the DJIA is down from 2007, -4.17%. Notice the profit margin, it is actually higher today than it was in 2007. There could be several reasons for this: increased efficiency, less “fat”/”perks” for upper management, delayed capital expenditures, or more importantly less employees. So we know that the average net income is down -4.17% from 2007, would you not expect then that the average stock price is down around the same percentage? In fact, it is down around -5.55% from an average of $48.44 to $45.75. So what we know so far from 2007 is that today’s average net income is down -4.17%, the average stock price is down -5.55%, and the average profit margin is up .53%. Although you may not be fully convinced to turn bullish on stocks yet, you will be shortly.

As mentioned before, I simply took the analysts’ word for it that revenue had not yet returned to the U.S. economy. But as an active investor, you must perform due diligence on the matter. Begin with a simplistic yet effective technique to find the average revenue of a company in the DJIA. Once again, the figures are in billions.

----------------------2007----------2008----------2009-----------2010
Avg. Revenue: $89,614------$95,815-------$85,517-------$90,431

Notice how the average revenue in 2010 is actually higher than in 2007!, although today’s revenue is down -5.62% from its peak in 2008. So are the analysts right that revenue is lagging? I tend to disagree, and have an incredibly important piece of evidence.

Looking back at the U.S economy of 2007 and the beginning of 2008, it was on fire! Business was good. . . .or was it?! First and foremost, oil was at an all time high!!!! The revenue and record breaking profits that Chevron(added to the DJIA in 2008) and Exxon were making had an incredible influence on the data. Second, the banks that are part of the DJIA: Bank of America (added 2008), J.P. Morgan Chase, Citi(replaced in 2009), and the notorious American International Group (replaced in 2008), all had incredible revenues due to soon to be toxic loans, and accounting profits from poisonous CDOs. In essence, revenues and profits were skewed by unsustainable and systemic risking products, practices, and prices. AND THIS IS WHAT ANALYSTS TODAY ARE COMPARING NUMBERS TO!?

Today, the revenue that is recorded and the profits that are earned are not only more truthful, but sustainable. Today’s businesses are growing with muscle instead of fat, vegetables instead of lard. For those of you who know that in order to make some large profits trading equities, stocks not only need to meet expectations but surpass them. From today and into the near future, growth expectations will be different; they will be more accurate and conservative. This creates an excellent opportunity to exceed those expectations and profit greatly.

And that’s why I am BULLISH on stocks.

 
Midas Mulligan Magoo:
Dow's a horseshit indicator. 40% of it's growth this year is off Caterpillar alone. Can't believe how much people love the taste of sacred cows even when their flanks go rancid.
Agreed with Midas - the Dow needs to crawl into a hole and die. It's not representative of the market, and the financial media should stop reporting on it. S&P 500 is a far better bellweather.

That said though, I don't think it entirely discredits your analysis. The only thing that worries me is that prices tend to move in ways that are not directly tied to underlying company performance - there is a lot of emotion and "humanity" involved. It brings you back to the old adage that even if you are right, "the market can remain irrational longer than you can remain solvent."

- Capt K - "Prestige is like a powerful magnet that warps even your beliefs about what you enjoy. If you want to make ambitious people waste their time on errands, bait the hook with prestige." - Paul Graham
 

Stupid question- there was a lot of talk about Citi making a profit due to decreased loan loss reserves. Does this mean that they reduced the amount of money they set aside for future losses, or did they actually take money out of the piggy bank to make it look like they made more money? Its been a hectic day, I haven't had time to look over the reports they released in depth, but I saw a lot of conflicting wording today.

They would be crazy in this fragile environment to take money out of the piggy bank, but I could see Citi doing this.

 

Couple of Points

  1. The increased margin is pretty normal in a recession. Company's trim the fat. My roommate works in a role now that used ot have 5 people, now one.

  2. Agreed that headline comparisons are crap especially for volotile, accounting influenced numbers like Net Income.

  3. I think you are guilty of poor comparison in your stock price change vs net income change. For one thing stock prices shouldn't track net income, but cash flow (from a fundemental perspective). Also, equity prices are two volatile to compare using that analysis. Also I don't like the runrate 2 quarters approach. I think you have to do an LTM comparison.

 

All very valid points. I wish I had better software to run a more complete analysis. For how simple it was, it actually took a long time.

In regards to the comment of using cash flow instead of net income, I understand it. Especially if I was running a DCF. How reliable is that?

In regards to the Dow being sh*t, I don't know. My largest fund was started on August 12, 2009, and since then, the Dow has outperformed the S&P500 by 1.5%.

In the end, I just wanted to bring attention to all of the chatter about lack of revenue of U.S. equities. I hope all of you have been long like myself and just making hand over fist.

Late

Yours truly, The Young Investor
 
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- Capt K - "Prestige is like a powerful magnet that warps even your beliefs about what you enjoy. If you want to make ambitious people waste their time on errands, bait the hook with prestige." - Paul Graham

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