There are a number of ways that a company can go about growing its earnings per share. The three primary avenues are to:
- Decrease expenses
- Reduce the number of shares outstanding (typically by buying back existing shares)
- Increase sales
While a company will hopefully be diligent about keeping costs reasonably low, at some point cutting operating costs below a certain level can actually slow a company’s ability to grow. Also, while buying back shares will certainly increase reported earnings per share (as the net earnings will be divided by a lower number of shares), this action does not increase the net profit, only the earnings reported per share. As a result, the preferred way for a company to grow its earnings is to increase the sales of its products and/or services.
Steadily increasing sales offers a company the best opportunity to increase its profitability. Virtually all products or services cost a company something to produce. But if a company has built its cost structure properly, it costs them less than a dollar to generate a dollar of sales. For example, if it costs a company $0.80 to produce a product that it later sells for one dollar, then for every additional dollar of sales the company generates it earns an additional $0.20 in profit ($1 in sales minus $0.80 in operating expenses).
What traders look for
In a nutshell, traders will analyze the size and consistency of quarterly and/or annual sales growth for a given company. The bottom line is that a company that consistently increases its sales revenues demonstrates an ability to sell more and more of its existing products and/or to introduce new products successfully. A company that can do this has a greater opportunity to increase its profitability than a company with flat or declining sales, which must either cut costs and/or reduce the number of share of stock outstanding in order to boost their profitability. For this reason, many fundamental traders will pay close attention to a company’s sales trends.
Sizeable sales increases are almost invariably a positive development, but consistency can be just as important. A company that shows small but steady increases in sales on a quarterly basis may be considered more favorably than a company that experiences a large increase in sales during one quarter or year and then a large decline the next.
There is no “magic number” in terms of annual sales growth that represents a cutoff between strong sales growth and something less. The best approach is to compare a company’s recent rate of sales growth to its own history and to that of other companies in the same industry group.
What traders look out for
Beware of a slowing trend in sales. At times, a fundamental trader may witness a situation where a company reports record earnings yet their stock price declines following the announcement. This is often due to slower than expected growth in sales or even a recent or projected future decline in sales. A recent or expected slowdown or decline in sales can call into question the sustainability of the current earnings trend, even if the current earnings trend is quite positive.
Sales are the lifeblood of any company. If a company cannot sell enough of its products to cover its operating expenses then eventually it will have no choice but to go out of business. On the other end of the spectrum, a company that can sell more and more of its existing products and/or to introduce new products successfully has a greater a greater opportunity to increase its profitability. In between the two extremes are the vast majority of companies that see regular swings in their sales figures. Finding a company with strong sales growth is one more fundamental factor that can help to identify potentially good stock candidates.