What is the base effect: when a weak last year makes this year's growth look large

Revenue growth is this year's sales minus last year's sales, divided by last year's sales. It cannot be built from this year's number alone; last year's number always enters as the denominator. With a smaller denominator, the same increase gives a larger ratio.

If last year's sales were 100 and this year's are 120, growth is 20%. If last year was weak at 60 and this year reaches the same 120, growth is 100%. This year's sales are identical in both cases, yet the growth rates differ fivefold. The difference comes from last year, not this year.

The prior-year value used as the point of comparison is called the base, and growth that looks inflated because that base was low is called the base effect. In the year after stores closed during an epidemic, after production stopped because of a strike or a factory accident, or after a large recall, sales returning to normal is enough to post high growth.

This is recovery, not growth. The business has only returned to the size it had two years earlier. Skip a year and compare with two years earlier, and growth over the two years turns out to be close to zero. In a year with unusually high growth, the first thing to check is whether last year was at a normal level.

If last year saw a burst of special demand or a large one-time order that made sales jump, growth comes out negative this year even though this year is normal. This year looks deflated because the base was high, which is called the reverse base effect.

Reading this as a worsening business gets it wrong in the opposite direction. Put the absolute size of sales side by side for three or four years, and a pattern where only last year jumped and then returned to its usual level looks different from a pattern that shrinks every year. The first is a reverse base effect and the second is an actual contraction.

When a company acquires a subsidiary, that subsidiary's sales newly enter consolidated sales and growth jumps; when it disposes of a subsidiary, that much drops out and growth plunges. The same applies to a year when a business unit is spun off or the accounting standard changes. Here it is the counting scope on this year's side, not last year's, that changed, so the cause differs from the base effect, but it mixes into the single growth number just the same.

When the consolidation scope changes, not only sales but also operating margin and the debt ratio move. What consolidated and separate financial statements count differently is covered in the article on consolidated financial statements. Checking whether there was an acquisition or disposal filing in the year growth jumped separates this case.

In the revenue growth distribution of Jupick's watchlist, the bottom quarter mixes companies whose business shrank with companies whose last year was unusually large, and the top quarter mixes companies that actually grew with companies whose last year collapsed and then recovered. A position in the distribution only says whether the value is common or rare in the market right now, not why the value came out that way.

Jupick does not filter out base effects. For Korean stocks it calculates year-over-year growth from sales in the annual report, and for overseas stocks it takes the year-over-year value for the latest quarter from the data source as is. Either way, the circumstances of the prior period used as the point of comparison are not erased; they come in as they are. Revenue growth is part of the profitability area of the overall grade along with ROE and operating margin, so a one-year illusion goes straight into that year's score.

In a year when growth is unusually large or small, four things are checked in order: whether last year's sales were at a normal level, what two-year growth compared with two years earlier looks like, whether an acquisition or disposal changed the counting scope, and whether operating margin moved in the same direction. In a year when sales recover, margins usually come back too, so if sales and operating margin moved together, the case is closer to recovery. In a year when an acquisition or disposal changed the counting scope, sales, operating margin and the debt ratio often shift in unrelated directions, so if the three do not move in step, the filings come first.

Growth rate is a number that summarizes the change between two years, and where that change came from is told by the absolute size of sales and by the filings. Metrics are a basis for reading a company's current condition; they do not suggest trading any stock and say nothing about future sales or prices. This content is for information only and is not investment advice. Investment decisions and responsibility for them rest with the user.