Where Do Earnings Come From

Sales and profit margins combine to produce earnings. It takes both. Here’s the formula:

earnings = sales x profit margin

I call it the E=SP formula. Memorize it, even if you hate math and flunked algebra.

The E=SP formula makes it clear that sales and margins both determine earnings. It’s tough for companies to report consistent earnings growth if sales rise, but profit margins drop, or vice versa. Let’s flesh out the concept with numbers.

Suppose that a company sold $1,000 worth of products during the last quarter at a 15 percent profit margin. According to E=SP, the company earned $150.

earnings = $1,000 x 0.15 = $150

If nothing changes in the next quarter, the company will again rack up sales of $1,000 and it will again earn $150.

That would create a problem for shareholders if it did happen because earnings growth, or the expectation of earnings growth, is usually what drives stock prices up.

E=SP tells us that the only way to boost earnings is to increase sales and/or profit margins. In the best case, good management can combine sales growth with growing profit margins, and then earnings grow faster than sales.

The bottom line number announced on earnings report day is earnings per share (EPS), which is net income divided by the number of outstanding shares.

earnings per share = net income/shares outstanding

A company with lackluster growth can boost its EPS by buying back its stock, thereby reducing the number of shares outstanding. Costco, Gap, Microsoft, Pfizer, and Walgreen results characterize most companies, with net income and earnings per share closely tracking sales.

Avon Products and IBM typify companies that, despite lackluster sales growth, still manage to grow earnings at a respectable rate by productivity improvements combined with share buybacks. Intel embodies the ideal situation; fast-growing sales and even faster growing earnings. That’s history, though. Notice that Intel’s sales growth slowed markedly in the 1997 to 2000 timeframe, even though the tech sector was flying high.

Cisco Systems, the fastest grower of the group, hasn’t done a good job of translating sales growth to profits. Worse, EPS growth didn’t track net income, reflecting Cisco’s inclination to use its stock to boost sales via acquisitions, consequently diluting shareholder value. Bottom line, you won’t go wrong starting with the assumption that, long-term, most companies’ earnings growth will track sales growth. In the short-term it’s a different story. Stock prices respond to all sorts of stimuli. It’s up to you to filter out the fundamentally significant information from the day-to-day noise.