Investing Series: What are profit margins and why do I care?
This is a part of the Investing Series.
Let’s care about margins today, specifically profit magins.
(We’ll talk about operating margins next week.)
UNDERSTAND THAT COMPANIES HAVE BUDGETS TOO!
Margins sound intimidating as a word until you think about it like a budget:
In a household budget, you make money, but you also spend that money (the fun part!).
What’s leftover in your budget, is your “margin”.
Now if you’ve got $0 left in your budget at the end of each month, you have nothing or $0 in profit margin.
If you overspent by $500 at the end of the month, you have a negative profit margin.
If you managed to save $500 at the end of the month, you had a positive profit margin.
Companies have budgets too. They have revenues (income), and expenses. What’s leftover at the end of the day, are their profits, and in relative to how much they make, they call that a profit margin.
WHAT ARE THE TWO MAIN MARGINS I SHOULD CARE ABOUT?
You should care about profit margins and operating margins.
(Actually not just in a companies, but in your own budget too)
I’ll chat about operating margins next week!
WHY DO WE CARE ABOUT PROFIT MARGINS?
We care that they make money, lots of it.. but also that they can save it.
You use profit margins between companies in the same industries to see which one is the better horse to bet on.
A company that has great profit margins versus one that has meager ones, is a more attractive purchase because the more money they make, the more the stock price goes up, and if they give out dividends, they may increase their dividend payout too!
Think of it like this: A person who makes $100,000 net a year, compared to another who makes $80,000 net a year.
If they both save the same amount of money (let’s say $30,000 each), it would work out to:
Person A ($100K) = 30% as a “profit margin” or savings
Person B ($80K) = 37.5% as a “profit margin” or savings
Person B who makes $80,000 a year is not only more frugal, but they’re someone you might want to invest money with because they know how to make their dollars stretch.
If you give them more money, like $20,000 more, you will see a better return on that money than if you handed it over to Person A.
A company works kind of the same way.
You want to know if they can make money, but also if they can save it by spending efficiently even when they make more.
HOW DO YOU CALCULATE A NET PROFIT MARGIN?
The two formulas are:
Net Income (after Taxes) / Revenues or Sales
Pretty easy right?
Both numbers can be obtained by reading this post here: Where do you find all that juicy financial info?
Much like a personal household budget, you basically want to know how much money they have in their pockets at the end of the quarter or the year for their retained earnings (a company’s version of savings) after things like taxes, which is why we say net and not gross, and companies utilize sophisticated corporate tax software to quickly obtain this calculation.
So if one year a company makes a lot of money but their profit margin (as in their sales or revenues) decreases because they sold more (but at lower prices), it’s not such a good deal.
One year, a company makes or has a net income of $100,000 from selling $50,000 worth of stuff.
$100,000 / $50,000 = 2
2 x 100 = 200%
They have a profit margin of 200%, which is pretty darn SWEET!.
The next year, let’s say the company makes $150,000 (a whole 50% more) as a net income, but they sold $100,000 worth of stuff.
$150,000 / $100,000 = 1.5
1.5 x 100 = 150%
They have a profit margin of 150% which is still sweet, but not as sweet as last year at 200%.
Although they made more money, they also sold more of their good and services but presumably at lower prices, or perhaps it just cost more to sell.
DO YOU HAVE TO ALWAYS USE NET PROFITS?
No, you can also calculate it using a gross profit, which would call it a Gross Profit Margin.
Gross Profit Margin =
(Sales – Cost of Goods Sold) / Sales
Gross margins are interesting because they tell you at the base what the company makes.
Of course, you always have to pay taxes, but some people like to know what the basic number is, and then drill down from there into details.
(You can also analyze the difference between gross and net profit margins and compare them to rivals in the industry, to see if they’re the same.)
SO WHAT DO THOSE PROFIT MARGINS MEAN FOR AN INVESTOR?
Taking that example above:
Could mean that Year One was a fluke year, and they just got lucky and some trendsetter somewhere just simply HAD TO HAVE that Beanie Baby, so their sales EXPLODED from other people following suit.
Or maybe Kate Middleton wore their boots/jacket/top/skirt/hat, and they completely sold out because of that unexpected press.
Could mean that it was a brand new product was introduced that no one had ever seen before, but by Year Two, more competitors entered at lower prices, and they were forced to lower their prices to stay competitive and relevant.
Could mean that the company is growing and wants to spread everywhere quickly to secure a market and a consumer base, which means they’re lowering their prices to grow faster.
Could mean that the company invested in a new system (distribution, computer, etc), and to recoup that money, their profit margins decreased.
Could mean that it just cost more money to sell, either by having to hire more labour, but they are in the stages of growing which means they’ll be inefficient for the first while until they get their costs under control.
It could mean a lot of things!
What you do want, is a company with fairly high profit margins because it means they have the cushion and the room to either lower their prices, take a hit in sales, and/or ride out tough storms in the economy.
A company with low profit margins, will take a fall a lot sooner than one with some room to maneuver with.
You’d need to read the headlines, understand why their profit margins went up or down, and then come to some speculations as to whether it’ll last, keep going up (or down!), and whether or not it’s a stable company based on other ratios to invest in.
Tune in next week for operating margins.
- Profit margins are basically how much a company is able to save each year
- It also shows how efficiently a company uses increased revenue to generate more savings
- A lot of income means jack squat if you don’t save any of it; this is true for companies too!