S&P 500: Show Us Revenue Growth

Can the future earnings of the companies in the S&P 500 sustain the recent rise in stock prices? During the earnings season for 2Q 2010 (89 percent of companies have reported), the S&P stock index has risen by a nice round 100 points, to 1125 from 1025, close to an equally round 10 percent. But as the stockbrokers like to say, we're investing in the future of these companies, not the past. How will the rest of the year, and 2011, compare to the encouraging second quarter? The answer likely lies in the strength of revenues companies can deliver, rather than the bottom line alone.

For 2Q 2010, earnings per share (EPS) of the S&P 500 companies rose about 29 percent, according to StarMine Professional, an analytical tool to which Reuters generously grants me journalist access. (A brilliant system -- StarMine gathers estimates from analysts, and weights them according to how accurate the analysts have been in the past.) For the coming 12 months, the analysts are forecasting profit growth of 22 percent for the S&P 500, down from 32 percent or so at the end of both the first and second quarters.

Let's consider a couple of other forecasts, from the smart people at Goldman Sachs and Barclays Capital. (Pardon the shabby formatting.):

S&P 500 Operating EPS Forecasts
Barclays Capital 2010: $76 +34% 2011: $80 +5%

Goldman Sachs (top-down) 2010: $78 +38% 2011: $93 +18%

Again, strong growth -- stronger in Goldman's view, but I think all three forecasts work out to about the same trajectory for profits. And both Barclays and Goldman believe the S&P 500 will move higher by the end of the year, to 1210 and 1260 respectively. (Let's hope that pans out; both firms employ a lot of smart people, but keep in mind that they are in the business of selling stocks and seldom speak ill of their products.)

The slowdown still leaves plenty of possible earnings growth, but the drop is nonetheless a meaningful amount. It's also a natural part of the process -- growth tends to slow over time, and especially so when there is slow growth in the surrounding economy.

For an expert's take on the meaning of the slowdown, let's go to David Rosenberg, chief strategist at Gluskin Sheff & Associates, Toronto.

He points out that one of the reasons profits have grown is that companies have been able to selectively cut their expenses, sending profit margins to record levels. Assuming the margins are vulnerable, he posits that the only companies that will sustain profit growth are those than can keep growing their revenues.

But that's not so easy: Rosenberg notes that in recent earnings reports, 38 percent of companies disappointed investors on the revenue front. And that has consequences (I've added some punctuation to make this passage easier to read):

Sales in Q2 are running at just +5.5% [year over year,] or basically 1/7th the pace of overall profit. The consensus for 2010 operating EPS is around $96, with margins hitting fresh highs. Revenues are seen rising 6.3% in 2011, which would imply a pace that is at least double nominal GDP growth...

Margins tend to be mean reverting, and... if we were to apply a 3% nominal GDP growth estimate for next year with profit margins heading back to the long-run norm, we would be talking about corporate earnings coming in closer to $71 per share.

And some shrinkage in the revenue growth, combined with flat or lower margins, would deflate earnings in a hurry. From Dave Rosenberg:

This then means that we are possibly talking about a forward P/E multiple of 16x, as opposed to the "cheap" 11.5x that everyone bandies about just because it is the "consensus view" - the same consensus that typically overstates earnings by an average of 20% at turning points in the economy.

Investors recognize the difference, and think more highly of surprise revenue growers than cost cutters, notes Goldman:

For the rest of the year, revenues will just as important as profits in validating share prices.