A few months ago during earnings season, the 30 companies that are a part of the Dow Jones Industrial Average shared with the public the status of their businesses. The results were spectacular; the market’s reaction was lackluster.

The analysts were saying that the market wants to see growth -- not just growth in earnings but growth in revenue. In essence, turning a healthy profit and even increasing dividends was not what the market was really looking for, and the stock price of these companies would not fully appreciate. It made sense to me. The market is forward-looking, and growth really determines the prices -- just look at P/Es, for example. But I couldn’t leave the topic alone. I had to dig further.

I have been long on equities since June and just can’t help to feel a bit bullish on stocks right now. Don’t get me wrong -- the economy, housing, jobs and fiscal deficits are painfully ugly. I couldn’t help but think about how a business works and, in particular, how a balance sheet and income statement work. If a company is making a profit and is not distributing 100% of it to its shareholders, then the rest is being added to retained earnings. If the retained earnings section of the balance sheet is growing, my portion of equity is also growing.

I understand that fundamentally stocks need growth not only in profits but in revenue too. In essence, one wants a company in the growth phase and not in the mature/declining stage. The media has talked so much about the lack of top line/revenue growth that I decided to analyze the bottom line/net income instead.

In a very simplistic manner, find the average net income of a company in the Dow Jones Industrial Average from 2007 through today. Note that the companies that make up the Dow have changed from 2007 to today. To find the value of 2010, I simply forecasted the firms’ statements from the first two quarters of data (net income is in billions).

As one can see, the average net income of companies in the DJIA is down from 2007, by 4.17%. Notice that the profit margin is actually higher today than it was in 2007. There could be several reasons for this: increased efficiency, less “fat” or ”perks” for upper management, delayed capital expenditures or fewer employees.

So if the average net income is down 4.17% from 2007, would you not expect then that the average stock price is down around the same percentage? In fact, it is down around 5.55%, from an average of $48.44 to $45.75.

So what we know so far from 2007 is that today’s average net income is down 4.17%, the average stock price is down 5.55%, and the average profit margin is up 0.53%. Although you may not be fully convinced to turn bullish on stocks yet, you will be shortly.

As mentioned before, I simply took the analysts’ word for it that revenue had not yet returned to the U.S. economy. But as an active investor, you must perform due diligence on the matter. Begin with a simplistic yet effective technique to find the average revenue of a company in the DJIA.

Notice how the average revenue in 2010 is actually higher than in 2007, although today’s revenue is down 5.62% from its peak in 2008. So are the analysts right that revenue is lagging? I tend to disagree, and have an incredibly important piece of evidence.

Looking back at the U.S economy of 2007 and the beginning of 2008, it was on fire! Business was good --or was it? First and foremost, oil was at an all time high. The revenue and record-breaking profits that Chevron (CVX) (added to the DJIA in 2008) and Exxon (XOM) were making had an incredible influence on the data.

Second, the banks that are part of the DJIA -- Bank of America (BAC) (added 2008), JPMorgan Chase (JPM), Citi (C) (replaced in 2009), and the notorious American International Group (AIG) (replaced in 2008) -- all had incredible revenues due to soon-to-be toxic loans and accounting profits from poisonous CDOs. In essence, revenues and profits were skewed by unsustainable and systemic risking products, practices and prices.

And this is what analysts today are comparing numbers to?

Today, the revenue that is recorded and the profits that are earned are not only more truthful but also sustainable. Today’s businesses are growing with muscle instead of fat, vegetables instead of lard. In order to make some large profits trading equities, stocks need to not only meet expectations but surpass them. From today and into the near future, growth expectations will be different; they will be more accurate and conservative. This creates an excellent opportunity to exceed those expectations and profit greatly.

And that’s why I am bullish on stocks.


Ryan Mitchell is the founder, editor and publisher of The Young Investor, where he provides current and relevant investment information to the young, ambitious and knowledge-seeking student. Previously, Mitchell worked with institutional currency exchange risk hedging at Baydonhill FX in London and was an adviser to institutional retirement programs in San Diego, Calif. Ryan has studied at the Imperial College of London and Stockholm University and holds a bachelor’s degree in finance from San Diego State University.