Investors typically trust the revenue figures more than they trust the net profit figures. However, revenues are prone to accounting shenanigans, just like their net income counterparts. I will leave the writing on accounting shenangians to a later day. This article focuses on using the disaggregation approach to detect fake revenue.
There are many methods to disaggregate revenue to get a sense of the reasonableness of the revenue figures reported; I will talk about three of them here.
Revenue can be disaggregated into price and volume. This is particularly relevant for consumer goods and industrials. Revenue can only increase if either price or volume increases. Investors should evaluate the pricing power of companies and determine if annual price increases are reasonable and sustainable. A company with no franchise is unlikely to have the ability to pass on increased costs to customers through increased prices. Volume increases should be matched with capacity utilization. If the company is running at full capacity utilization and still shipping out increasing volume of goods, investors should be skeptical.
Revenue can be disaggregated into average revenue per user and the number of users. A good example will be social networking firms like Facebook (FB). There is a natural cap on the number of Facebook users, in terms of demographics and market penetration. If a social networking company announces it has 70% of the country's population as users in a country with 30% internet users, the numbers are unrealistic. Average revenue per user is dependent on the purchasing power of consumers in their countries and spending habits. Similarly, a country with users spending $10 per transaction offline is not expected to have users spending $50 per transaction online.
Revenue can be disaggregated into industry revenue and the company's market share. Total industry revenue figures can be extracted from sell-side analyst reports, market research reports or company presentations. It is not reasonable for the market leader to have 70% market share in the industry, when the second largest player claims 40% market share. One of them is lying. A simple test to detect fake revenue, using this approach, is to compare the company's growth rate with the industry's growth rate. If the company grows faster than the industry year on year, there are only two possibilities. One is that the company is actively stealing market share from competitors. The other is that revenues are fake.