Evaluating Company Sales and Costs
Sales (also known as revenue ) tell you the dollar amount of goods and services a company sells. This is important because what it really tells you is the amount of money being brought in as a result of the customers' desire for whatever the company is selling. It is also important, however, to know how much it costs to sell the goods and services offered by the company. This cost is called the Cost of Goods Sold.
When evaluating the possibility of investing in a company, growth in sales is what really matters-not just the level of sales. The reason growth in sales matters is that as an investor you want to know that the demand for a company's products or services will be increasing in the future. If the demand for a company's products or services is high, it is more likely that the company will continue to make more money in the future. And the money a company makes helps determine its stock price.
It is important for a Teenvestor to find out why big changes in sales may happen from year to year. If the change in sales is because the company sold some of its operations to another company, then a decrease in sales doesn't mean that the company is doing poorly. If the decrease in sales is because no one wants what the company is selling, then that is bad news.
Because good Teenvestors invest in stocks for the long term, small decreases in sales over a 1-year period may be no big deal. It is important to know the underlying cause of the change but there may be no need to panic with a small decrease in sales. However, if sales have been going down steadily over the past 3 years, we recommend that you try some other company.
On the other hand, sales figures could suddenly increase for a company, not because it sold more of its goods and services, but because the company purchased or merged with another company. An increase in sales due to mergers or acquisitions does not tell investors anything -- good or bad -- about the demand for a company's products or services.
Once again, as is the case in all of our analysis, you must compare the sales growth in the company you are researching with the growth in the industry. There are sites that can give you the sales growth averages in specific industries. In general, sales growth of about 10% is considered good for large-cap companies. For mid-cap and small-cap companies, sales growth of over 20% is ideal.
Cost Of Goods Sold
While sales or revenue growth is important, the cost of making those sales, referred to as cost of sales or cost of goods sold (COGS) is also very important. Keep in mind that cost of sales refers only to the cost of the materials or labor used to make the products sold or the services delivered.
COGS does NOT include 1) Selling, General & Administration Expenses (SGA): expenses not directly related to the products or services sold such as rent, lease, utilities, salary, marketing, etc., 2) Research & Development (R&D): investments companies make in developing new and better products or services, 3) Interest, Taxes, and Depreciation (ITD): the cost of paying interest on loans, taxes owed, and depreciation on buildings and equipment.
Professional investors pay close attention to the cost of sales because when it increases it reduces a company's earnings-and earnings drive stock prices. In general, a company's sales should grow faster than its cost of sales.
Here is a simple example to illustrate why you have to consider the growth of COGS along with the growth in sales. Let's suppose that you run a lawn-mowing business and you rent the lawn mower each time you have a customer. You charge $50 to mow big lawns and it costs you $10 to rent the lawnmower and to fill it with gasoline. The $50 you collect for mowing a lawn is the sales or revenue and the $10 is the cost of sales. This means that each time you mow a lawn, you earn a profit of $40, which is calculated as the sales or revenue of $50 minus the cost of sales of $10 ($50-$10=$40).
If your cost of renting the lawnmower goes up to $20 all of a sudden, the profit for each lawn you mow will go down to $30 ($50-$20=$30) unless you raise the price you charge. You can probably raise your price a bit, but there is a limit how much more your customers will pay for you to mow their lawns. Your customers probably won't like it if all of a sudden you raise your price by $10 and charge $60 to mow their lawns so that you can still maintain your $40 profit ($60-$20=$40).
On the other hand, you can try it, but you may loose a few customers. If you raise your price by just $5 instead of $10, so that you now charge $55, you may lose fewer customers. Your profit will be $35 ($55-$20=$35) instead of the $40 you were making originally. But if expenses keep going up, there is only so much you can do to maintain a reasonable profit in your business.
Many businesses are faced with the same dilemma of rising expenses as described in the previous example. As their expenses increase, they too have to increase their prices so that their earnings aren't significantly reduced. For many businesses, however, increasing prices to make up for higher expenses result in losing some customers. Some businesses end up compromising by raising prices somewhat (but not fully) to cover increased expenses. In the long run, the stocks of businesses whose expenses are growing faster than their revenue, are not attractive investments.