The Bottom Line on Top-Line Growth


By Sam Stovall According to some accounts in the financial media, while earnings for the second quarter are coming in better than expected, revenues have been either flat or declining. The commentators worry that continuing lackluster revenue growth indicates that the economy remains weak -- and that the accounting sleight-of-hand employed to pump up earnings in past periods is still rampant.

Is that really the case? A review of a daily report produced by Howard Silverblatt, Standard & Poor's index analyst, shows that these concerns appear to be unfounded.

PRIME NUMBERS. As of July 28, 2003, more than 70% of the companies in the S&P 500-stock index had reported results for the quarter ending June 30. Combining recently reported earnings figures with remaining estimates, S&P calculates that operating earnings for the S&P 500 will be 1.7% ahead of S&P's bottom-up estimate (generated by combining S&P analysts' forecasts for individual companies) for the June quarter and 13.7% above the year-earlier actual figure.

S&P 500 June-quarter results

% change from

6/30/03 est.

2002 qtr.

Operating EPS

1.7%

13.7%

"As Reported" EPS

11.3%

58.4%

Sales

-2.9%

8.7%

On an "as reported" basis, current-quarter and full-year results are also very favorable, as comparisons benefited from accelerated writedowns in 2002. And sales, although about 3% behind our quarterly estimate, are still projected to advance nearly 9% from a year ago. ("As reported" earnings and sales estimates are generated by S&P's economics department.)

To me, growth of 9% is neither flat nor lower. Besides, earnings growth usually outpaces sales growth, right? Well, not according to history. In the past 32 years, surprisingly, sales growth has been higher and less volatile than "as reported" earnings growth.

Compound growth rates

S&P Industrials composite

Sales

As Reptd. EPS

Share Price

Nominal GDP

CPI

1971-80

11.5%

11.5%

4.3%

10.4%

7.8%

1981-90

6.1%

4.4%

9.6%

7.6%

4.7%

1991-00

3.7%

8.1%

14.7%

5.4%

2.8%

2001-02

-3.5%

-35.3%

-18.9%

3.1%

2.2%

1971-02

6.4%

4.6%

7.5%

7.5%

4.9%

Standard Deviation

6.3%

21.4%

17.4%

2001-05 (est.)

3.8%

2.7%

4.5%

4.5%

2.1%

From 1971 to 2002, sales for the S&P Industrials composite index (the S&P 500, minus the financials and utilities sectors) grew at a compound annual rate of 6.4%. By contrast, figures for earnings were 4.6% and 7.5% for the share-price value of the index. The 2001-02 results dramatically affected the overall results. Excluding 2001-02, sales, earnings, and share prices posted compound growth rates of 7.1%, 8%, and 9.5%, respectively. (I chose to look at the S&P Industrials, since only 10 years of sales data are available for the full S&P 500.)

The year with the highest earnings growth was 1994, at 49.7%, while the sharpest drop came in 2001, with a decline of 63%. The Industrials index posted its best and worst one-year performances in 1975 (+31.9%) and 1974 (-29.9%). By decade, the growth trends for sales, earnings, and gross domestic product steadily declined, but so did the rate of inflation. And as inflation dropped, annual growth in share prices rose, returning 7.5% compounded. Interestingly, that figure was equal to the nominal growth rate of the economy as a whole.

A CLOSER LOOK. It appears that the financial media may be overly concerned about top-line growth, since, over the past 32 years, sales have at least kept up with, if not outpaced, earnings more often than not. But I believe this analysis has yielded an even more important conclusion: That it's unrealistic for investors to assume that sales, earnings, and even share prices will outpace the growth in the overall economy for an extended period of time.

Using S&P's forecast for nominal GDP growth (unadjusted for inflation) in the coming years and applying the same relative growth ratios from 1971 to 2002 to sales, as-reported earnings per share, and share-price growth, investors should expect sales, earnings, and share prices for the S&P Industrials to advance at an annual compound rate of between 2.7% and 4.5% during the first half of this decade.

Industry Momentum List Update

For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of July 25, 2003.

Industry/Sector

Company

S&P STARS* Rank

Biotechnology/Health Care

Amgen (AMGN)

5 STARS

Broadcasting & Cable TV/Consumer Discretionary

Comcast (CMCSA)

5 STARS

Computer Storage & Peripherals/Info. Tech.

Storage Technology (STK)

4 STARS

Consumer Electronics/Consumer Discretionary

Harman International (HAR)

Not Ranked

Distributors/Industrials

Genuine Parts (GPC)

1 STAR

Gold/Materials

Newmont Mining (NEM)

4 STARS

Internet Retail/Info. Tech.

eBay (EBAY)

3 STARS

Internet Software & Services/Info. Tech.

Yahoo! (YHOO)

3 STARS

Office Electronics/Info. Tech.

Xerox (XRX)

2 STARS

Reinsurance/Financials

Everest Re (RE)

Not Ranked

Wireless Telecom Svcs./Telecom Svcs.

Nextel (NXTL)

5 STARS

* S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (strong buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell). Stovall is chief investment strategist for Standard & Poor's


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