The short answer to your questions are, "It can mean a number of
things," "Not necessarily," and "Probably not."
First, the numbers in the annual report are almost certainly correct,
if not necessarily useful. The SEC examines annual reports with a
magnifying glass, and few companies are bold (and stupid) enough to
tell a flat-out lie. And before the report goes to press, dozens of
people have probably looked at the numbers. For the most part, the
financial data is accurate.
Very few companies see sales and profits rise at the same rate.
Profits depend on a lot of things other than sales, such as operating
expenses, production expenses, taxes, and a host of other cash and
noncash items that affect the income statement. PepsiCo just declared
a per-share profit gain of 14% on a sales gain of 6%. For Pepsi, this
meant profit margins were widening. Family Dollar Stores posted 7%
lower per-share profits on 10% higher sales, mostly because of higher
expenses and a trend toward sales of less-profitable items. This is a
company that spends lots of money to build new stores, but right now
isn't getting much growth at its existing stores. Thus, lower profits.
In a perfect world, you want profits to rise faster than sales,
because it usually means the the company is operating more
efficiently, and thus becoming more profitable. In real life, a
declines in profit margins can be caused by literally hundreds of
factors, most of which are more irritating than truly dangerous. Few
companies can keep improving profit margins ad infinitum.
As for whether you should sell the stock, consider the reason for the
divergence between sales and profits. If a software company is
expanding into the low-margin consulting business, you should expect
profits to grow slower than sales, because margins are falling.
Companies with high fixed costs, like manufacturers, utilities, and
retailers, often see profits rise or fall at sharply higher rates than
sales. And it's not uncommon to see profits fall while sales rise
during periods when businesses are spending heavily to expand, or when
the cost of doing business is rising. Such situations sometimes mean
the stock is in for a hard time, but not always. Keep in mind that the
market is fairly efficient, and if the environment for a business or
an industry is poor, much of the outlook is probably reflected in the
stock price already.
If profits are rising faster than sales, that's generally a good
thing, unless sales growth is stagnant, and the company is cutting
costs to the bone just to generate profit growth. If profits are
rising slower than sales, that's often a bad thing, but not
necessarily reason to sell the stock. If profits are falling while
sales are rising, that's usually a bad thing but, once again, not
necessarily enough to sell the stock. There may be a logical,
defensible reason for the decline. If both sales and profits are
falling, you'll probably want to sell the stock. However, there are
exceptions even to that last negative scenario. One is energy stocks.
Most oil drillers are expected to see sales and profits fall next year
because of a drop in commodity prices. If the stock is reasonably
valued and well-positioned in the market, you may want to keep it.
The only way to make a sale decision is to consider this factor
(divergence between sales and profits) in the context of other
information about the company, its industry, the market, and your
changing investment needs.
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