The Earnings Trap
One of the traps you can fall into is investing in a company whose earnings are going up but whose revenues are going down. This is a divergence between earnings and revenues. If the divergence continues for too long a time, watch out!
There's something very wrong with the picture of a company that is making better and better earnings on less and less revenues. The question you have to ask yourself is, How long can this continue?. No company can continue forever to earn more money on less revenues.
Yes, earnings are important. But don't place earnings above revenues. If you do, you fall into The Earnings Trap. The trap is believing that earnings are so important that you can afford to ignore revenues.
Why is rising earnings on falling revenues a sign of trouble?
Perhaps the company leadership is giving the company away. It's possible to do this by sacrificing future earnings for the sake of present day earnings.
An even more extreme possibility is an accounting irregularity. If this is the case, stay away. Stay away!
Because earnings and revenues are so closely related, you want these two trends going in the same direction. When earnings are going up, you want revenues going up too.
If revenues and earnings are both on the rise, you have yourself a good company.
©Edward Abbott 2003