Revenues or Earnings

Most investors know what the term PE means. It simply means price of stock divided by the earnings per share. It is a basic and yet important measurement to determine the pricing of a stock. Is it overpriced or cheap? As we become more sophisticated in our analysis of public stocks, we will use the PE of a stock to compare the value of that stock to other stocks in the same sector. We can even value the stock based on a PE to the overall market. It's a basic but important analysis tool.

When I invest in small cap stocks (For purposes of this blog, it usually means OTCBB or Pink Sheet stocks), I tend to disregard net income, earnings per share and PE's unless the company is doing at least $10 million in revenues. In the small cap market, I really am focused on the revenue growth. Let me explain.

Take for example a company that in 2004 did $2.7 million in revenues and earned $900,000. Most investors would conclude that the profit margins are good. But in the following year, what would excite me more?

1. $2.9 million in revenues and $1.3 in net income.
or
2. $9 million in revenues and $150,000 in net income.

Scenario number 2 will cause a buzz among sophisticated in investors. Scenario number 1 typically leads to a good, healthy yawn. Why?

Scenario 1 doesn't tell me much. Does the company have room to grow? Did they lay off employees? Did they cut back on advertising expense? Did they save on a new healthcare plan?Does management know how to grow the company?

Scenario 2 tells me one thing. The company is growing and many more people are now buying their product or service. A few years down the line and if profit margins are still low, I'll start to ask questions about the business margins. However, at the early stages of growth, I am always interested in the revenues more than earnings. It's a good rule to remember. If I want profit margins, I'll buy blue chips. If I want Scenario 1, I'll invest in the local restaurant.