Great Expectations: Forecasting Sales Growth

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Great Expectations: Forecasting Sales Growth
by Ben McClure

Predicting a company's top line growth is arguably the most important part of determining its stock growth. Unfortunately, unless you are a company insider with accurate order and shipment data, it's awfully difficult to know precisely how many products a company will sell in, say, the next five years. But by working through a few key questions, investors can improve the accuracy of their guesswork: How quickly is the market for the company's products growing? What is the company's share of the market? Is the company likely to win or lose market share?

Market Growth
Take some time to examine the market growth rate. Is the company doing business in amature market or a growth market? Let's say you are trying to gauge the future growth of consumer product giant Proctor & Gamble. It's worth remembering that the market for P&G's goods is fairly mature, which means that it probably won't be growing much faster than the overall economy or the GDP.

Players in the technology industry typically operate in faster growth markets. Take for example the company Research in Motion. A few years ago, you wouldn't have seen too many people using the company's Blackberry handheld computers, but you see plenty of them today. To get a sense of Research in Motion's prospects, you need to estimate the percentage of people who already have handheld computers, the percentage of new handheld computer buyers, and the percentage of customers that Research in Motion may be able to grab from competitors in the years to come.

Market Share
A company's market share can also have a big impact on its future sales growth. Does the firm--like the computer chip giant, Intel--dominate its market? It's hard for Intel to grow sales by, say, 10% a year when its annual sales are already $33 billion and it owns over 80% of the chip market. For some dominant players, there is only so much room for growing sales via gains in market share.

Other times, major market players use already strong market positions to make even more gains. Coffee retailer Starbucks and auto maker Honda are good examples of companies that have used their brand power to grow market share consistently over the years.

"Up-and-comers" can very quickly take large market share percentages from those companies who were traditionally dominant competitors. Think of Southwest Airlines. Thanks to an innovative, low-cost business model, in just a few years Southwest grabbed a big chunk of the airline business from industry leaders such as American Airlines and United Airlines.

Some companies are constantly "trading" market share with competitors. If you are considering sales growth at Coca-Cola, you might want to estimate growth from gains in market share; however, when market share swings back and forth between rivals, say Coca-Cola and Pepsi, you shouldn't put too much weight in share gains when estimating future sales growth trends.

Pricing
Pricing of products and services can have a big impact on sales revenue growth. If a company increases its prices and manages to maintain unit sales volume, then sales revenue will grow. On the other hand, higher prices can lead to fewer units sold if customers turn to less expensive alternatives.

The effect of prices on sales revenue all depends on the company's pricing power. Pharmaceutical companies, for instance, have enormous pricing power when their drugs are under patent. The same goes for companies with a lot of brand recognition and customer loyalty. Starbucks and Honda can charge higher prices than their competitors and still maintain sales revenue growth. By contrast, in technology and consumer electronics markets, it's almost inevitable that prices will fall. For companies like Sony and Intel, pricing pressure over time can be so strong that sales revenue may fall even when units sold rises.

Finally, don't forget to think about the product mix. Let's say General Motors decided it was going to focus on selling its high-end Cadillac cars over its lower-end Chevrolets. The higher average selling price of the luxury cars could end up having a favorable impact on sales growth--assuming that GM's focus on the high-end doesn't translate into fewer total cars sold.

Conclusion
For investors looking at a company from the outside, forecasting sales growth rates--even in the near term--is a bit like looking through the fog. These simple questions about market growth, market share, and pricing power are just a start. But they can get investors a long way.  
by Ben McClure (Contact Author | Biography)

Ben is director of McClure & Co., an independent research and consulting firm that specializes in investment analysis and intelligence. Before founding McClure & Co., Ben was a highly-rated European equities analyst at London-based Old Mutual Securities.