that over time help you to identify those well-managed companies that you want to own for many years versus the ones that experience growth in short periods of time—and ultimately lose money for their investors.
Relationship between Revenues
3. Mergers and acquisitions. In the past, merger and acquisition activ- ity was quite high. Markets have gone through phases of leveraged buyouts and the use of mergers to create favorable financial re- sults. Aside from these strategic reasons for mergers, there is also a competitive reason. Corporations may buy smaller competitors to eliminate them as well as to expand their own market share. A well-timed and carefully structured acquisition or merger can help improve overall financial performance and justify the cost of pur- chasing another company. Even so, there are only so many com- petitors worthy of buying; so if a corporation is undergoing a large volume of mergers and acquisitions, it should raise your suspicions. Also, in attempting to estimate long-term revenues based on current trends, remember that acquisition-based revenue growth is not going to recur every year.
4. Product line diversification. Just as investors are encouraged to di- versify their capital, corporations also need to diversify their product or service lines, for several reasons. First, diversification helps protect corporate cash flow against cyclical change. Second, it opens up new markets and helps continue healthy revenues and earnings trends. Third, diversification may become necessary when a product becomes obsolete. For example, Altria Corpora- tion has expanded away from its previously dominant domestic tobacco sales as U.S. opposition to smoking has had an effect on sales. Altria’s international tobacco sales and food division rev- enues are gradually replacing cigarette sales in the United States.
5. Geographic expansion. Corporations can open outlets overseas.
The global economy is becoming more typical and less of an odd- ity today, compared to the past. Many corporations are already multinational in nature and international revenues represent ma- jor portions of overall revenues. While some industries are domi- nated by Asian corporations (notably in manufacturing and related industries), there remain many others such as retail, en- ergy, and IT (information technology), that continue to expand overseas rapidly. International markets present potentially high revenues growth for many corporations. For investors, identifying industries likely to benefit from increased international activity, and then finding the corporations likely to benefit the most, is a sound way to choose companies for long-term expansion.
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All of these sources for higher revenues are finite. No growth can continue forever without slowing down and eventually ceasing. This is a reality in any analysis of long-term revenues and earnings. So even in the most successful instance, and even when corporations employ all of the methods listed above to create and continue revenue expansion, there is a natural limit. Successful companies evolve with changing times, to take advantage of ever-growing markets. History shows this to be the case.
IBM was originally founded as a typewriter repair company. For many years IBM dominated repair and manufacturing of manual and electric typewriters. When it became apparent that the home computer would soon replace typewriters, IBM quickly reinvented its primary rev- enues model, replacing typewriter manufacturing with a new product line: computer hardware.
Similar examples can be found in virtually all industries. Prudential used to be known primarily for its whole life insurance business, as well as other insurance products. Today, Prudential is one of the major finan- cial advisory concerns, with services ranging from investment banking to research, financial planning, and other related services in addition to in- surance. Today, many large banks also are involved in financial services and investments as related service areas.
In retail many interesting trends are underway. The standalone fran- chises of the past are now found in growing numbers in larger stores or opened in combination with other franchises. Starbucks Coffee has hun- dreds of stores, but new franchises open up as often as not in grocery stores or in combination with other food franchises. Food courts in malls, highway access areas, and even downtown centers are seeing more and more combination Taco Bell and Burger King outlets in single buildings and fast food attached to service station convenience stores. These combi- nations cut overhead while exposing the stores to good volumes of traffic.
These marketing trends are examples of emerging strategic planning, taking advantage of high-volume traffic areas with reduced or low over- head setup. Even so, revenues are only one half of the revenues-earnings equation. While there are many ways to increase revenues over time, earn- ings may grow, but have greater limitations.
Each industry tends to experience a relatively narrow range of earn- ings, normally expressed as a percentage of revenues. So if a likely range of earnings is going to be between 12 and 15 percent of revenues, it is not rational to anticipate ever-expanding earnings growth beyond the 15 percent range.
Even as corporate revenues expand, costs are going to be fairly fixed and expenses can be kept at the same level only to a degree. As a result, you can realistically expect the margin to remain within the likely range in comparison to revenues. But as long as the dollar amount of revenues continues to expand, earnings will grow in dollar amount over time. A 15 percent return of $100 million in revenues is $15 million in earnings;
the same 15 percent on $200 million of revenues will be $30 million in earnings—same percentage, but greater dollar amount.