An investor must comprehend how revenue enters a corporation and transforms into profit. Here’s how it all works, including instances of unusual cost structures.
Revenues and profits offer good signs for our investments, but they aren’t interchangeable terms. Both represent important factors to help us understand our investments better.
Revenue growth and increasing profits represent the companies we all want to buy.
Companies like Microsoft, Google, and Amazon continue to grow revenues at death-defying levels, with little sign of slowing down. Combine those with profit growth, and we have successful businesses. Understanding the differences between revenue and profits will give us insight into the operations of Microsoft, for example.
As the markets continue to fluctuate, the desire to find profitable companies with continued growth remains the benchmark.
In today’s post, we will learn:
- Revenue vs. Profits: Why Do We Care?
- What Are the Different Types of Revenue Sources?
- What Are The Three Types of Profit?
- What’s More Important: Revenue or Profits?
- Revenue & Profit Examples from Real Companies
Okay, let’s dive in and learn more about revenue vs. profit.
Revenue vs. Profits: Why Do We Care?
Revenue equals the total a company generates from selling its products and services. We can refer to these as the top line or top line sales.
Typically, the revenues represent sales from the core operations of a company. For example, Walmart’s primary source of revenue is groceries, but they generate sales from other merchandise.
The amount of income left over after deducting all costs, obligations, new sources of income, and operating costs is known as profit, which is also known as net profit or the bottom line.
Profit refers to net income after deducting expenses from earnings, whereas revenue refers to income gained through business operations. Sales, fee-based, and property-based income are just a few ways money might come in.
Even if a business generates significant revenue, no profit will be left over if expenses outpace income.
Every company generates revenue; the trick is to find companies that can continue growing. For example, if we look at the companies in the railroad industry, we find multiple companies enjoying revenue growth. But we also see some growing faster than others. And digging deeper, we see some generating higher profits than others.
Revenues tell us a lot about the product or service’s popularity, along with the strength of the brand, moat, and marketing.
But profits give us insight into the operational expertise of the company and how well they can turn the brand or moat into profits for the company and shareholders.
Remember: revenue equals sales, while profits equal the amount a company keeps after deducting costs, taxes, debt, and expenses.
So why the focus on revenues vs. profits?
As a company generates revenues or sales, those sales flow to profits, and the best way to evaluate a company encompasses all of these different comparisons. Analysts and investors need to look into how a company generates revenues and how profitable those revenues can become.
The two components remain intertwined and help investors determine the best investments. We want companies that generate strong, continuing revenues along with growing profits. That remains the best of both worlds.
What Are the Different Types of Revenue Sources?
The phrase “revenue” refers to earnings from operations. Sales are the most common source of revenue, but a company may also make money from fees, interest, rentals, taxes, gifts, grants, investments, and other sources.
Revenue (more technically, gross revenue) is the first line of the company’s income statement, and many refer to it as the top line.
The whole amount of sales a business generates is its gross revenue. Companies will label sales differently depending on their different business models, which I will explain more in a minute.
You will see different line items from companies labeling the top line as gross revenues, top-line sales, or simply, revenues.
Remember that each business model might have different ways to generate revenues, so not everyone will have the same source of revenue as Microsoft.
Some companies will list gross revenue, which encompasses how they create sales from their products or services, and the gap between gross revenue and directly connected costs is net revenue.
Gross revenue equals total sales for Costco from both merchandise and subscription revenue. The cost of goods sold, which includes materials, labor related to merchandise, and inventories are all subtracted from revenues to achieve gross profit.
Different companies from different industries will list their revenues or top lines differently. For example, Bank of America lists its revenues as total revenues from two avenues:
- Net interest income
- Noninterest income
Because banks generate revenues from two different methods, one relates to interest income from loans, credit cards, and lines of credit, and the other stems from fees for services and commissions for sales.
Similar to banks, insurance companies list their revenues a bit differently. For example, Progressive, the car insurer, has a different-looking income statement than Bank of America.
They list their revenues by three main sources:
- Net premiums earned
- Investment Income
- Net realized gains on securities
These revenues stem from the premiums we pay for our car insurance, for example, investment income from buying or selling stocks/bonds and any dividends they receive from these investments.
I can hear you; what do I care about banks and insurance companies?
Well, understanding the different business models allows us to understand how a company generates revenues, which flow to profits.
The last difference in revenues comes from the payment industry.
For example, Adyen, the Dutch payments company, lists its gross revenues as the top line, but the money they keep minuses the transaction fees they pay its partners, is called net revenues.
And then, finally, we have a “normal” company like Microsoft, which lists revenues as its top line while breaking the total revenues into two parts, and the extra profit centers further down on the income statement.
It can all seem confusing but rest assured, the different terms will make sense once you understand the business model.
What Are the Three Types of Profit?
Net income refers to the term used to describe profit on the income statement, but most people refer to it as the bottom line. The income statement contains different types of profit used to analyze a company’s success.
For example, we have three different profit margins separated on the income statement between the top line or revenue and the bottom line or net profit.
These three line items help us differentiate between the three sources of revenue and how well the company controls the costs to generate those revenues. Revenue flows down the income statement through these three profit centers to reach net profit or earnings.
Revenue less Cost of Goods Sold (COGS), the direct expenses related to producing the products a business sells, equals gross profit. A company’s direct labor expenditures and the cost of the materials needed to make its products are both included in this sum.
Operating profit equals the sum after removing all operating costs such as sales, R&D, marketing, and administrative, for example. These costs are associated with the direct operations of the business. For example, Intel spends money on R&D to create new semiconductor chips. And Crowdstrike spends money on sales to help generate leads for their subscription business.
These operating costs are removed from the gross profit and represent a starting point for free cash flow. Operating profits also help investors determine the returns on capital or ROIC.
What’s More Important: Revenue or Profit?
The conventional answer is profits offer a complete picture of a company’s health.
To be a complete investor, we must consider all factors in our assessment.
While net profits represent the company’s overall profitability, companies can manipulate them. Revenues, for the most part, offer the most reliable source of information on the income statement. Revenues remain the hardest line item to “fudge.”
That is not to say that it doesn’t or can’t happen, but it is rarer to see.
The easiest way to think about whether one is more important than the other is to consider the different kinds of investors.
For example, some want to focus on the top line or revenues and work their way down the income statement. We refer to these types of investors as growth investors or bottom-down type investors.
The other example is bottom-up investors, who focus on the bottom of the income statement or earnings and work up from there. These investors believe the net income tells a complete story related to company health.
The blunt fact remains that neither is better, and revenues can’t exist without profits and vice versa. There is no right or wrong answer here.
You can find and have great companies with great revenue growth but modest profits; on the opposite of the spectrum, you can have great companies with modest revenue growth but strong profits.
Let’s take a look at a few examples.
Visa, the payments juggernaut, has grown revenues over the last five years at an 11.5% pace, while earnings have grown 19.29% over the same period. Both metrics represent a strong company, but the question arises, “How can they grow earnings faster than revenues?”
The answer lies in earnings growth as the company grows revenues, which flow down to the net income. As Visa improves its profitability or generates more operating leverage from its business model, it can generate higher profit margins.
And then we have the fact that Visa has bought back its shares at 2% annually over the last ten years. The continual reduction in share count helps Visa improve its earnings per share over time.
Put these two factors together, and we have earnings growth faster than revenue.
Visa would relate to a more bottom-down approach combined with an analysis of the margins.
Another example of this type of thinking relates to Walmart. Walmart has generated 5.54% revenue growth over the last five years, with earnings growing 2.17% over the same period.
A bottom-down investor would get too excited about Walmart’s annual growth, but a bottom-up investor might not get excited about Walmart’s net income growth.
Does this indicate Walmart is a band investment?
No, but we need to consider Walmart’s business model. When we think deeper about Walmart and its business model, we can see they focus on selling low-cost items for a slim margin. They do this to entice customers to shop there, leading to lower margins and margin growth.
Revenue & Profit Examples from Real Companies
Let’s look at a company’s income statement and analyze its statement related to revenues vs. profits.
For our guinea pig, I would like to look at Microsoft, using their income statement from the latest 10-K, dated June 30, 2022.
Let’s take highlighted sections from the above picture and put them into a table to help us better analyze Microsoft’s income statement.
Cost of goods sold
During 2022, Microsoft generated $198,270 million in revenues from its products and services. We can see from the table above that those revenues cost Microsoft $0.32 for each dollar of revenue.
The company generated gross profits from its costs, equaling a gross profit margin of 68.4%, indicating the company creates $0.68 of profit for each dollar generated.
If we look at the operating efficiency, we see the company generating $0.42 of profit from each dollar of sales. Moving to the net income, Microsoft generates $0.37 for each dollar of sales.
In solo, it’s hard to tell if these are good or bad.
But, a great practice is to look at longer trends to see how the company has done. I use stratosphere.io to help me chart the revenue and profit ratios over the last ten years to see trends.
From the above chart, Microsoft continues to grow revenues over the ten years displayed. But we can also see the growth of both operating and net income, while the gross profit has remained steady.
The next step would be to compare those numbers to competitors to see how the company performs compared to others.
We can see from the above chart that Microsoft and Google have generated similar revenue growth and gross margins, which bodes well for both companies.
We can also see that Amazon generates tremendous revenue growth with lower gross margins.
It’s not quite an apples-to-apples comparison because of the nature of their business models; Amazon carries far more retail which tends to drive down margins.
Costco, our next guinea pig, generated $226,854 million in revenues, with a growth rate of 15.8% for 2022. Those revenues created the following profit margins:
- Gross profits – 12.1%
- Operating profits – 3.4%
- Net profits – 2.6%
The first thing that jumps out is the much lower margins than Microsoft, which goes back to their business models. To get a better sense, let’s look at the long-term performance of Costco’s margins to see if these are random or normal.
The above chart indicates Costco operates on lower margins, and the business model leads them to operate this way.
Microsoft and Costco operate from different cost structures and generate different margins. Most of Costco’s costs stem from inventory, whereas Microsoft sees costs as operating costs.
It is important to understand business models and how a company generates revenue.
Revenues represent the income a company generates through the sales of its products and services. Profits represent the net income or bottom line after deducting all costs/expenses to generate those revenues.
Revenue and profits tie together companies’ income statements or P&L, and they can’t exist without each other.
As investors, it is helpful to understand the terminology and how they interact with each other. It is also crucial to understand the business model to understand better the company’s revenue generation along with its profits.
The understanding also enables better comparisons, both within and with competitors.
And with that, we will wrap up our discussion regarding revenue vs. profit.
Thank you for reading, and I hope you find something of value. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,