Revenue, the top line
Source: Buffett & Clark; Lynch
Revenue, also called sales or the top line, is the money customers paid the company for its products or services over the period. It is the first line of the income statement, before any costs are taken out. Every other number flows down from here, so it is where you start.
Growth in revenue is good, but the kind of growth matters more than the size of it. Ask where it came from:
- Did the company sell more, or just charge more? Growth from selling a larger number of units is healthier than growth that leans entirely on price increases, which customers can only take for so long.
- Did it grow on its own, or by buying other companies? Growth a company produces from its existing business is called organic. Growth bought through acquisitions is not the same thing, and it often hides whether the core business is actually getting stronger.
- Will it happen again? A one-time licensing deal or a single big contract can puff up a year and then vanish. Recurring revenue, the kind that repeats each year, is worth far more.
- Who is paying? If one customer makes up 40% of sales, losing them would be a disaster. Spread-out customers are safer.
The best businesses grow revenue steadily through good times and bad. Companies whose sales swing wildly with the economy, like carmakers and chip makers, are called cyclicals, and their single-year numbers can mislead. Look at several years at once.
The margin ladder
Source: Buffett & Clark, chs. 4-17
Below revenue, the statement subtracts costs in stages, and at each stage you can measure a margin. A margin is just a profit divided by revenue, written as a percent. The three rungs of the ladder, from top to bottom, tell you three different things.
- Gross margin is what is left after the direct cost of making the product, called cost of goods sold. It measures pricing power. A high, steady gross margin, usually above 40%, means customers will pay a premium that rivals cannot undercut. A gross margin that shrinks year after year is a sign that competition is catching up.
- Operating margin is what is left after the cost of running the company day to day: the sales team, the offices, the research. It measures how well management controls those costs. Compare it to direct competitors, where the gap between the leader and the rest is meaningful.
- Net margin is what is left at the very bottom, after interest on debt and taxes. A net margin held above 20% for years is rare and is a strong sign of a lasting edge. Average it over five years so a single odd tax year does not mislead you.
Two costs sit inside operating expenses and deserve a look on their own. Selling and admin costs (the sales force, marketing, head office) should stay a small share of gross profit in a lean business. Research spending is more interesting: Buffett tends to avoid companies that need to spend heavily here, because an edge that has to be constantly reinvented is a weaker edge than one that simply lasts.
Below the operating line
Source: Buffett & Clark, chs. 11-18
After operating profit, three things stand between the company and its final profit, and each tells you something.
- Interest. This is the cost of the company's debt. Compared to operating profit, it should be small, under about 15%. A company whose interest swallows much of its operating profit is one bad year away from trouble.
- Tax. The tax the company actually paid, divided by its pre-tax profit, is the effective tax rate. It should sit near the normal rate for the country and stay steady. A rate that jumps around from year to year hints at one-time items or aggressive tax maneuvering, and it makes the bottom line harder to trust. (In the DuPont breakdown this same idea shows up flipped, as the tax burden, the share of pre-tax profit the company keeps after tax.)
- One-time items. Charges for layoffs, write-downs, or lawsuits land here and can hide the real trend. Strip them out in your head to see what the business earns in a normal year.
The last line is earnings per share, or EPS, which is profit divided by the number of shares. It can rise for two very different reasons. Either the company earned more money, or it bought back shares so the same profit is split fewer ways. Only the first is a stronger business. Always check whether total profit is actually growing, not just the per-share figure. Use the diluted share count, which adds in the extra shares that in-the-money options, restricted stock, and convertibles would create, so you are not fooled by a count that is about to grow.
What value investors look for
Source: Buffett & Clark
Pulling it together, here is the short list a value investor runs down on the income statement, always across several years rather than a single one:
- Steady revenue growth, mostly organic and mostly recurring.
- Gross margin above 40% and not shrinking.
- Selling and admin costs under about 30% of gross profit, held steady.
- Net margin above 20%, averaged over five years.
- Interest costs under about 15% of operating profit.
- A steady, normal tax rate, without strange swings.
- Profit per share rising because total profit is rising, not only because of buybacks.
A company that clears most of these for a decade is showing the fingerprints of a real, durable edge. None of them proves anything alone. The signal is in seeing them hold together, year after year. Next, the balance sheet tells you whether the company is built to last.