About six years ago, I bought a stock at $5 a share that I later sold for more than $30 per share. That's a 500% increase.
Not bad, right?
Well, it so happens it's in an industry that has outsized sales -- in this case, $600 billion projected for 2013, according to an industry association. But I've long since found that great sales are not enough.
What's the industry? Airlines, where major U.S. airliners fly at more than 80% capacity and not-quite-out-of-bankruptcy American Airlines is boasting record sales for July.
Pretty impressive, you say? Not so fast.
The International Air Transportation Association also reported a 1.6% profit margin for the industry -- the after-tax profit is $10.6 billion and the revenue stream is highly dependent on rises and falls in fuel prices.
That's not to say airlines are a bad investment. It's just that you need to look at more than sales revenue. Here are 4 things you should know about big-revenue companies before you invest:
1. Revenue Is Different Than Profit.
Revenue is just straight sales. Profit is the amount of money left after expenses have been deducted. For instance, airlines have labor, fuel and equipment costs in addition to other expenses. Before a dime is shown as profit, all expenses must be subtracted from revenue. 'It is not what you make it is what you keep,' Rob Seltzer, CPA and personal financial specialist says.
2. The Profit Margin Is What Matters Most.
Profit margin is the percentage of revenues that is actually profit. The airline industry spent well over $600 billion to earn about $10 billion. Seltzer says, 'Sales are great, but if your margins are not good and your costs are too high relative to your revenues, then you have problems.'
3. One-Time Large Purchases Can Have A Huge Impact.
Airlines have to buy big items like, you guessed it, airplanes. A one-time purchase such as an airplane can impact profits greatly. Therefore, the next quarter's profits could be much better. Always compare revenues and profits with a previous quarter, preferably one from the season the previous year.
4. Revenue Can Rise And Fall For Many Reasons.
'One thing I would look out for is this: 'The company's bottom line [profit] looks better than past year, but sales revenue is down,' says Michael Eisenberg, CPA and personal financial specialist. 'How could that be? Expenses have been cut more than sales are down.' If expenses were cut because new planes are more fuel efficient or gas prices dipped, cutting expenses has a positive effect on your investment — but not cuts in wages.
'Bottom line: More people out of work or more people with fewer working hours,' he says. 'That could spell trouble in the bigger picture for the economy because people have less money to spend.' A worsening economy can mean less people flying or buying products and even lower profits.
The Investing Answer: Pick companies to invest in based on whether the price of the stock is worth it. When I bought airline stock that I sold for six times the value I bought it for, I looked at previous stock prices as well as projections. I also did it with a clear understanding of profit margin and expenses that did and could incur.
It's important to discuss with a finance professional, CPA or financial planner, why you want to invest in a company with high revenue but not necessarily high profit margins. They may reassure you that it's still a great investment or convince you to invest in a mutual fund or other stocks instead. Just make sure he gives you the reasons for his decision so you can make your own.