It all starts with the "top line" - the first line of the income statement, which shows revenue or, as it is more commonly known, sales. In reality, though, the first line does not always shows all revenue, or the revenue we need for investment valuation purposes. Sometimes it shows "gross revenue", of which the actual revenue to the company could be just a small portion. Often the revenue part of the income statement consists of two or more lines, showing a split of revenue by category. At the end, we are usually interested in total revenue, which is always present on the income statement, though not necessarily at the top line.

The revenue number is not of that much interest to us on its own: what we are after is the pair "revenue - revenue growth". These are, by far, the most important input factors in any valuation model based on forecasting future cash flows. Therefore, an extreme care should be taken in selecting and adjusting (if needed) both the revenue and revenue growth numbers to be used in the company valuation.

Sometimes the company management goes to great lengths to embellish the company's condition and to hide any unfavorable developments. Normally, this is done within the framework of generally accepted accounting principles (GAAP) or other accounting methodology permitted by law in the country of the company's residence, but shear legality of this does not make it acceptable for the purposes of valuation.

There are two major caveats that an analyst should take into account when selecting or calculating the magnitude of the revenue he should use in valuation.

First, we are primarily interested in organic revenue growth. The analyst should determine how much of the company's stated revenue growth rate came from organic growth and how much of it resulted from acquisitions. Quite often, especially in cases when investing community pays large premiums for growth, achieving and maintaining such growth becomes an overriding obsession of the company management - as they know only too well that if the growth expectations fail to materialize, the stock price of such company will crash - literally crash, not just correct.

The easiest way to achieve high growth is through acquisition of other companies - very often at inflated prices. When this happens, the analyst should value the company on the pre-acquisition basis and make separate valuations of each of the acquired companies. This is much easier said than done as the analyst has to take a set of consolidated financial statements of the company and make from it at least two sets (one for the acquirer and one for each of the acquisition targets) - as if the acquisition did not happen.

Second, we need to make sure that the revenue numbers were not artificially inflated or deflated (though the latter case is not a common practice, theoretically, it is also possible). The two most common examples of inflation are:

• putting gross sales in revenue (e.g. when the company acts as an intermediary or broker in a sales transaction and books the nominal value of the transaction as its revenue – instead of booking only its commission), and
• recognizing revenue prior to actual completion of the sale transaction in its economic sense (delivery of product or service against payment); this results in accelerated buildup of accounts payable and accounts receivable on the company's balance sheet, which means that the product or service has not been quite delivered yet.

There are many more potential reasons for adjustment of the revenue and revenue growth rate the analysts should be aware of. They are not always apparent even for a trained eye and quite often require a detailed study of the complete set of financial statements and accompanying notes to them. At the end, the true picture should be discernible from the company's official reporting - unless it is fraudulent, of course.