Understanding Revenue

A company provides a service or sells a product to consumers. These consumers need to continually purchase the product/service for the company to grow. This is the main reason why revenue stream is important. Understanding this point unlocks huge possibilities for identifying high value investments in public markets or in the real economy. See below for revenue streams that unlock clues to sustainable increase in value and apply that knowledge on valuing companies. Get familiar with these clues and recognize them the next time you perform due diligence on a company. Look here to learn how to find a company’s revenue stream.

To assess a company’s value, make sure to check out our link here: How to Value a Company

Recurring Revenue Streams

You must identify why consumers will continue to purchase a product or a service in the future. Service companies are naturally recurring because consumers pay monthly to gain access to some sort of service. A company doesn’t need subscription-based revenue to provide high value. Great consumer brands and food companies also have great recurring revenue. Some examples are:

1. Trash: There are monthly fees for trash pickup, also any sort of economic activity creates waste. Trash is always a recurring revenue stream.

2. Utilities: Monthly fees for electricity, gas, water, etc.

3. Communications: Monthly fees for internet and phone lines.

4. Real Estate: Monthly rent payments.

5. Entertainment: Netflix, Disney plus, and other streaming services are monthly subscriptions.

6. Insurance: Monthly premiums.

7. Food Service: People need to eat every day and a good fast burger like McDonalds has made a living on that for decades.

8. Caffeine/beverage: Companies that sell caffeine with a brand are highly lucrative. People love caffeine and will keep buying it every day.

9. Retail: This is way more cyclical, but a strong retail brand is hard to beat. People are group think creatures and love fashion. Look at Nike and Lululemon through the years.

There most definitely are industries and revenue models that I’ve missed but you should get the point. Subscription/recurring revenue models provide stable revenue streams throughout time if the service continues to be valuable. There is an extra value bonus if the company’s variable costs decrease as time goes on. Variable costs are costs directly associated with the revenue. For example, a company like Netflix provides a subscription service via website and application. Variable costs including hosting and backup costs. Will those costs decrease over time or at least not increase at the same pace as revenue and create margin expansion? A company with subscription or recurring revenue is a great start but there must be pricing power to maintain those cash flows.

Pricing Power

Pricing power is, well, powerful! A company has pricing power when it can raise the price of product and services. This pricing power enables a company to continually price products to keep pace with inflation. The pricing power also allows for products to outpace inflation to create further value for stockholders. Pricing power is much harder to recognize than other variables, but a few key indicators are:

1. The company has a strong brand like Netflix, Disney, Apple.

2. The company has strong contract power: Trash, utility, and real estate companies historically have great contracts in place to lock consumers into services and build in price increase stipulations

3. The industry is highly regulated: Highly regulated industries can create monopolies of sorts. The industry is usually a high need, capital intensive, and the price point is set at a point where it’s unattractive for other companies to enter. Utilities, healthcare, and Communications fall in this bucket.

4. There are more reasons for pricing power like capital intensity and intellectual property.

Costs of Revenue

A company’s revenue stream has a direct variable cost component. Meaning that with every unit sold, the company has to fund an input cost. Understanding revenue stream is important in understanding the costs associated with the revenue. You can identify the gross margin attached to the sales and identify if this margin can expand. Meaning the cost of revenue declines. For example, in the communication/technology end user sector, cost of production is continually decreasing. AOL charged customers $10 a month just to use email for a fixed number of hours in 1999. Today, email and many other platform accesses are free to use (aside from advertisements but we’ll cover that later). You want to find a company that has recurring pricing power with cost of revenue that is declining.

Summary

Finding good recurring revenue with pricing power and declining costs is very tricky, but that’s why revenue stream is important. Master it, and you shall have great portfolio growth. To learn more about the accounting or calculations, visit Investopedia.