“Baby, we were born to run.”
With the booming stock market and the focus on exploding revenue growth, run rates and calculating them, plus their uses, is a timely metric to understand.
Every quarter, companies hold earnings calls with analysts, which allow investors to hear from the executives running the show. And get their thoughts on the performance and prospects of the company. In the calls, revenue is a common topic, and one of the terms thrown out is “run rate.”
The metric is a simple one to calculate, but it is more important to understand its meaning and how to interpret the ratio.
Every company wants to see revenues grow, but many are cyclical. Take restaurants; for example, most make the majority of their revenues on a cyclical basis, with the holiday season for many being the high season. We will cover more about that in a moment.
In today’s post, we will learn:
- What is Run Rate?
- How Do You Calculate Run Rate?
- Why Do Companies Use Run Rate?
- Run Rate Examples from the Real World
- Investor Takeaway
Okay, let’s dive in and learn more about run rates.
What is Run Rate?
The run rate, according to Investopedia:
“The run rate refers to the financial performance of a company based on using current financial information as a predictor of future performance. The run rate functions as an extrapolation of current financial performance and assumes that current conditions will continue.”
The run rate sometimes refers to dilution from company stock option grants, but that is a rabbit hole for another day.
One aspect of the run rate that is great is that we take the company’s performance and project it into the future by using current financial information.
Any projections based on that information assumes there are no changes forecasted in the future.
Run rates are very common among new companies, especially companies that have finished IPOs recently. Using a run rate allows investors to project revenues into the future and predict margin improvements and profitability.
Typically, run rates refer to projections based on quarterly numbers, but it is also possible to use weekly or monthly data. Most projections are on an annual basis and are typical for rapidly growing companies; for example, Uber, Tesla, Airbnb, Doordash, and Spotify.
Using a run rate also allows investors to get a sense of the size of a new or growing company while also putting those revenues in context.
The run rate is most often associated with revenues or sales but is also possible with any line item you wish to project. For example, if you want to project the company’s gross margin, you can project the revenues and costs to see how the margin might look over the entire year.
How Do You Calculate Run Rate?
The formula for calculating run rate is simple:
The run rate looks at information from the company’s financials and extends it over a longer period.
For example, let’s say that Spotify (SPOT) generates revenues of $2,326 million from the quarter ending September 2020. To project those revenues over the period, we take that quarterly number and multiply it by four.
That calculation generates a revenue run rate of:
Spotfiy run rate = $2,326 x 4 = $9,304 million
Pretty simple, huh?
When we use a process like the one from above, we also refer to it as annualizing the data.
Let’s expand on this idea and look at the run rate of costs for Spotify so we can look at the extension of the company’s gross margin.
Spofity costs run rate = $1,750 x 4 = $7,000 million
Now that we have the run rate for the costs, we can look at the projected gross margin for Spotify.
Run Rate Projections
That is pretty cool, and it is a great way to analyze any company. Seeing the numbers laid out helps make ideas a little more real while also indicating what is possible.
Currently, Spotify is not profitable, but the revenues have grown exponentially since its IPO. One way to use these types of projections or calculations is to adjust the margins to see the company’s run-rate to become profitable.
We can also take the run-rate projection and calculate a growth rate based on those quarterly numbers. Spotify’s revenues from the year ending 2019 were $7,516 million, and the TTM (trailing twelve number) is $8,557 million. If we take our projected run rate of $9,304 million, we can look at the small sample size to find a growth rate.
Rate vs. 2019
That an interesting chart, and if we look at the growth rate of the revenues for Spotify over the last four years, it is a CAGR (compounded annual growth rate) of 24.34%.
If we compare the company’s historical growth rate versus the run rate we are projecting, it looks like it is a realistic projection based on historical performance.
Why Do Companies Use Run Rate?
Companies use run rate for young companies that have only been in business for a short time. Revenue run rate, especially for a company with growing revenues, can be a powerful tool for CEOs to raise funds.
A young company with growing revenues might use the run rate to generate excitement further while raising money. Because the young company might not have a strong credit rating or no credit rating, using a revenue run rate tool can help them raise funds to continue operations or growth.
There are a few instances where using the run rate is beneficial:
- For younger companies, using the run rate allows you to project sales numbers and profitability. As you are starting, it is helpful to project whether you are meeting your sales targets.
- Another instance is when a growth company’s metrics start to turn from negative to positive. In most instances, early public companies lose money, but over time, as they grow, they start to turn positive. Using run rates allows you to put those positive numbers in perspective.
- Suppose there is a fundamental change in the business, for example, if the company shifts its focus to cost-cutting and can grow your profits from $80,000 a year to $120,000. Then projecting the profitability from $320k a year to $480k a year is a better indicator.
As there are benefits, there are also risks to using run rates; let’s look at those next.
Changes in the environment
The use of run rates, especially revenue run rates, make the critical and sometimes unrealistic expectation that nothing will change in the economic environment. It assumes that the conditions that created that revenue growth will continue forever.
Mr. and Mrs. Market are actual maniacs and to assume they will allow everything to continue as before is foolish. The modern markets are unpredictable, erratic, and decisions based on a run rate take a big risk.
Use of the run rates assumes nothing changes in the upcoming environment. And many businesses are seasonal or have seasonal variances.
As I mentioned in the beginning, the restaurant is quite seasonal, and depending on its location in the country, has a large bearing on its seasonality. The holiday season for many restaurants is a huge boon for their business; early October thru Mother’s Day is their busiest time.
Therefore, projecting a revenue run rate for a business such as Darden based on the Olive Garden’s revenues during the fourth quarter or December will over-estimate the year’s revenues.
Another great example is Target, Walmart, and Amazon during the holiday season. That period from Black Friday to the New Year is a tremendous revenue driver for all three businesses. If we project the year’s revenues based on that period, we will overestimate by quite a lot.
Changes in company performance
As with seasonality, any changes in the company’s performance are not considered with run rates. For example, companies like Apple and Microsoft see growth in revenues when they release a new product like an iPhone and Xbox.
If we calculate a run rate using the quarter that Apple releases a new iPhone, then we run the risk of skewing our data and overstate the run rate.
Run Rate Examples from the Real World
Let’s take a look at some of the run rates for a few select companies to see how it might work and within the context of the run rate timing.
For example, by estimating revenue run rates based on seasonality or special situations.
First up, let’s look at Walmart (WMT).
Walmart, in their annual report, outlines their quarterly results in the notes section.
Let’s project the company’s revenues based on the second-quarter revenues and the fourth-quarter revenues for a comparison.
Walmart Run Rate
Q Revenues x 4
2nd Quarter Revenue
$128,028 x 4
4th Quarter Revenue
$138,793 x 4
I took all the above numbers from the 10-k for the year ending 2019; I thought it best to avoid the Corona year to see how a “normal” year might look.
First, the actual annual sales for Walmart at year’s end was $514,405 million. So, the second quarter projection was quite close to the actual output.
Next, if we look at the fourth quarter projection and analyze its relationship to the actual revenues, we see that the company would have a 7.9% higher figure than the actual result.
That is a big number, and an eight percent growth in one quarter, especially for a mammoth company the size of Walmart. And we can see how that would throw off our calculations if we were assuming an eight percent increase for the year.
Okay, now let’s look at some revenue run rates for some of the newer businesses in the market.
Revenue x 4
Looking at a chart like above is an interesting exercise because we can see in the chart companies that are growing revenues beyond the last twelve months of revenues, at least on a projected basis.
For “growing” businesses like Snowflake, Uber, and Beyond Meat, the businesses have yet to turn a profit.
Let’s take a deeper look at Uber to understand how much they need to grow their revenues to achieve profitability. Keep in mind we are dealing with the pandemic year, so the numbers are skewed as 2020 doesn’t qualify as a “normal” year.
The gross profit margin for the quarter ending September 2020 for Uber was 48.42, and the quarterly revenue was $3,129. If we assume the company has fixed costs, and those don’t accelerate at the same rate as the revenues. Then we need a revenue run rate of a certain size to achieve profitability.
The biggest issue for Uber is overcoming their SG&A expenses; if those are normalized, the company can become profitable.
So the CAGR or annualized revenues for Uber currently is 38.5% over the last four years. If we take the quarterly revenue and increase it by 38.5% and then calculate the run rate for it, we can see if that is enough to make it profitable.
Run rate = $3,129 x 38.5% + $3,129 x 4 = $17,334.66
Now, we can look at the total costs and expenses:
- Costs – $6,579
- Operating expenses – $11,360
- Total expenses – $17,939
Now, comparing the run rate for revenues and the expenses, we can see that we are coming up a bit short, but it is in the ballpark.
Now, several questions leap to mind. First, is 38.5% revenue growth reasonable to expect? Second, are the costs going to remain fixed or in a related state that they are better controlled than revenue creation?
The answer is, I don’t know, and that is okay; we will not have every answer in the book. But the better question is to ask whether we think those assumptions are reasonable?
In my mind, the revenue number is HUGE! But it is based on historical trends that the company has achieved. So that is in the realm of possibilities, but the controlling of costs is a far bigger gray area at this point for Uber.
Calculating run rates is a simple process, and it is a great exercise to see how on track the company is for any sales projections that the company offers.
Building models based on the run rates of the different line items is also a great practice for valuations and projections for profitability. Many growth investors focus on top-line growth, but having an overall picture is the best.
By utilizing a run rate on items such as expenses, you get a better sense of the company’s operations and the management’s control of those expenses and costs.
One of the bullish theses I have heard about Uber is once the company establishes its base, the fixed costs of its infrastructure or platform will stabilize, allowing for profitability to occur.
All of that is contingent on continued revenue growth because of the nature of Uber’s business, it being a tech company. The margins expectations rival Microsoft and Facebook, which are 25 to 35% net income margins.
Using run rates on any line item from the financials you choose is a great way to look at companies’ projections. Focusing on the different sections will help give you a better sense of the business’s interrelations.
With that, we will wrap up our discussion on run rates.
As always, thank you for taking the time to read today’s post, and I hope you find something of value in your investing journey.
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,