Profit performance nearly always suffers in an economic downturn. The reason for this is the interplay between Fixed costs, Variable costs and Revenues.
Revenues can drop overnight. Costs on the other hand cannot be trimmed anywhere near as quickly. Fixed costs, Rents/Mortgages, Debt interest payments, Wages/Salaries to name a few are very sticky and cannot be cut due to their contractual nature. Variable costs, Energy, Commisions etc can generally be reduced proportionately.
The result is bad, or terrible. It is simply bad if Net Profit falls. This is due to the very short term nature of Wall St, where EPS is watched hawklike. Falling Net Profit, in a high multiple growth company will almost invariably reduce the shareprice.
Terrible however is where falling Revenues drive a fall in EPS and concurrently falling cashflow. This is potentially a bankrupting development. Growth companies generally show rising EPS while showing falling cashflow in a growth cycle.
In a business contraction, EPS growth will fall and potentially go negative. In a strong business, this can drive an increase in cashflow via the Receivables, Inventory and Accounts Payable accounts. If however these accounts still drive a negative cashflow result, the implications are very serious.
Thus while evaluating potential value plays in smaller companies, cashflow becomes a much more important consideration. Liquidation values are a good starting point in the search for value.
