Although profits are the most significant factor driving stock prices long term, sometimes revenues are more important in the short term. For example, when IBM (IBM - Free Analyst Report) reported that share earnings advanced a healthy 12.5%, year to year, in the 2010 second quarter, the stock price initially dipped 3%, because total revenues rose only 2%. Investors were expecting better revenues, which would have indicated that IBM was fully participating in the recovery of the technology sector of the economy. Instead, the company generated a solid share-profit gain, via a 1% decrease in operating expenses, a lower tax rate, and fewer common shares outstanding. In addition, bookings in the large computer services division declined, possibly suggesting that the economic recovery was losing steam.
While companies can cut costs to boost operating margins in the short term, investors may worry that the bottom-line improvement may not be sustainable in the longer term without some top-line growth. During the first half of 2010, corporate profits rebounded sharply from the depressed year-earlier level, helped primarily by aggressive cost cutting. However, there is a big question mark over the relative strength of the economy in the second half of 2010. If the macroeconomic environment is favorable over the balance of this year, economically sensitive companies would probably continue expanding profits through higher revenue levels. If the economic recovery stalls, then corporate profits could be pressured by sluggish sales.
This logic points out how important it is to examine revenue trends, when analyzing individual stocks and when trying to gauge the strength of the overall economy. Of course, the analysis changes somewhat, depending on what sectors of the economy are under review. Non-cyclical companies, such as health care and consumer staples firms, exhibit more-moderate fluctuations in sales and earnings through an economic cycle, while cyclical companies can produce material swings of their top and bottom lines. In summary, companies can widen operating margins by reducing expenses or increasing revenues -- or by a combination of the two. So far this year, corporate profits have been lifted mainly by the expense-reduction method, and it appears that the stock market is currently uncertain as to whether corporations can continue their earnings uptrend with the aid of higher sales.
While profits at the major (S&P 500 type) corporations are coming in at a relatively strong pace, revenues at these companies, in the aggregate, are still below their pre-recession levels. Investors will have to monitor the sales growth of representative companies in select sectors to help determine the magnitude and timing of the economic recovery. Because the health of the economy is dependent on the improvement of the employment picture, the near-term outlook has been limited by the stubbornly high level of joblessness.
The U.S. economy appears to be in a “Catch 22” predicament. American companies are reluctant to start rehiring large numbers of workers, until they are sure that American consumers will purchase their products. And American consumers are afraid to begin buying in bulk, until they know that their paychecks (and their jobs) are safe.
There has been, in the short term, a decoupling of corporate profits from the creation of jobs. Right now, higher earnings at the Fortune 500 companies are not leading to higher U.S. employment. Several reasons could be responsible for this detachment: Corporations are investing in their overseas operations, because profits are growing there; companies are investing their cash in labor-saving technologies that raise productivity without adding to payroll materially; corporations are paying dividends to shareholders and repurchasing stock in order to boost their stock prices.
In conclusion, the current economic environment illustrates how sales can be more important than earnings when analyzing a stock or an industry. While short-term profits can benefit from cost-cutting measures, a sustainable bottom-line recovery usually requires growth on the top line.