“Sure, earnings are going to be fine this quarter, but sales growth has been tepid.”
I am hearing this line a lot in the financial media lately and frankly, it is a theme that is being given way too much airtime. All else equal, would earnings grow faster if sales were also growing faster? Sure. But that does not mean that earnings growth this quarter (tracking at 5-6%) is somehow bad news for investors. All too often it seems that people forget that stock prices are based on earnings, not sales. Why? Because shareholders in public companies are entitled to a proportional share of the firm’s free cash flow. Sales have nothing to do with it.
Don’t buy that argument? Think about the dot-com bubble. Why did the internet stocks tank beginning in March 2000? Because the companies were not making any money and after a while investors refused to pay 20 time sales when they were used to paying 20 times earnings. I could set up a web site that sells dollar bills for 95 cents and it would be hugely popular. Think of how fast I could grow the site’s sales!Â But an investor would never give me any money because the business model does not work. Stock investing is all about placing a value today on profits to be earned in the future. Sales growth is irrelevant in that context.
Consider a real world example. IBM has doubled its stock price from $100 to $200 since 2009. IBM is expected to book sales of $102 billion this year, versus $96 billion in 2009. If sales growth really mattered, IBM’s stock would not have doubled in four years because it only grew sales by 1.5% annually. Earnings per share, on the other hand, have risen by 70% during that time. That fact, along with some P/E multiple expansion, explains the stock’s performance. Don’t get caught up in the revenue growth debate. Earnings are what matter.