The answer the Bloomberg Radio reporter gave to the question, “Why sales, not earnings?” was that sales are harder for a less-than-honest company to manipulate. In some highly abstract and technical way this might be true, but in any practical sense the reply is ridiculous. Stuffing the channel is a time-honored, easy to do way of inflating sales.
Still, there are instances where an investor will want to look at sales rather than earnings.
1. Value investors looking for turnaround situations will seek out companies with lots of sales but little in the way of earnings. They’ll benchmark the poorly performing firm against a healthy rival in the same industry. They figure that if the two firms have comparable plant, equipment and intellectual property, then a change of management should enable the weaker firm to achieve results that are at least close to what the stronger one is posting now.
As I see it, this mindset is what separates value investors from their growth counterparts. The latter, myself included, begin to salivate when they see a strong bottom line; the former are magnetically attracted to big sales/no profits firms instead.
2. Especially in the tech world, companies often go public before they become profitable. AMZN, which didn’t report black ink for eight years after its IPO, is the poster child for this phenomenon.
Potential investors routinely look at the size of the market a given firm is addressing and the rate of its sales growth as a way of gauging its potential value. This is a tricky thing to do, since it requires us to decide how much of the money the company is now spending is akin to capital spending–one-time foundation laying that won’t recur–and how much is spending that’s needed to generate each new sale. Put a different way, it’s a decision on what is SG&A and what is cost of goods. As AMZN illustrated, there’s huge scope for error here.
(An aside: I attended an AMZN IPO roadshow presentation. Management mostly said that during the PC era investors could have bought then-obscure companies like MSFT and CSCO and made a fortune. The internet age was dawning and AMZN offered a similar chance. Nothing but concept.)
3. A simpler variation on #1 + #2, which is currently being worked vigorously by activist investors at the present time, is to find companies that may not break out results by line of business but which in fact operate in two different areas. In the most favorable case for activists, the target firm will look like nothing special but have one high-growth, high-profit area whose strong performance is being obscured by a low-growth low/no-profit sibling. The activist forces a separation, after which growth investors bid up the price of one area, value investors the other.
Obviously, no one uses just one metric. But the way I look at it, the only persuasive case for using sales as the keystone to analysis is the value investor use I outlines in #1.