Margins are the core of a business’s profitability. Ultimately, any business lives or dies by its ability to generate more money than its costs, a difference that we call a profit margin.

This is also something that can be really confusing for beginner investors, as there are several different types of margins. This article will look at the differences between those types and the ways we can use them to evaluate a business and its stock.

The Different Profit Margins

There are three main types of profit margins that you’ll see commonly listed and discussed on stock research sites.

1. Gross Profit Margin

This is the margin that does not take fixed costs into account.

👉 For Example

Take a can of tomatoes. Let’s say the tomatoes cost $1, and the can costs another $1. This is $2 in costs that occur for every can produced.

If each can sells for $4, the gross profit margin is 2/4 = 0.5 = 50%.

For more complex operations, the calculation at the company level will be:
Gross profit = Net sales – Cost of goods
Gross profit margin = Gross profit / Net sales

Generally, net sales are equal to the “revenues” line in the income statement. A more detailed explanation is net sales = gross sales - returns & discounts.

Most companies will report their gross profit margin, but you can calculate it yourself with the formula above.

Gross profit margin tells us how much money the company makes from making and selling its product, ignoring fixed costs. This does not tell you how much money the company makes, as it still needs to pay for equipment, taxes, etc… But it tells you how profitable the actual manufacturing of the products is.

2. Net Profit Margin

Net profit margin is how much money the company actually earns from its sales. This does include all costs, including fixed costs like investment, inventory costs, taxes, etc.

You use the following formula to calculate the net margin:
Net profit margin = Net income / Revenue

👉 For Example

So if a company makes $500M in revenue and $100M in net income, its profit margin is 100/500 = 0.2 = 20%.

For every $1 of revenue, the company makes 20c of income.

The net profit margin is very important, as this is the profit that will be available for investing in growth or R&D, distributing dividends, buyback stocks, acquiring other companies, etc.

3. Operating Profit Margin

This is also known under terms like “income margin”, “return on sales,” or “EBIT margin”. All of these mean the same thing.

It takes into account all the costs needed to run the business day-to-day, like administrative overhead, operating costs, sales expenses, etc… What it does NOT include are taxes, debt costs, and other nonoperational expenses.

To calculate the operating profit margin, you use this formula:
Operating profit margin = operating income – revenue

The advantage of operating profit margin is that it gives a clear view of the profitability of the core business operation.

For example, the company’s overall profit might be low if it makes substantial debt payments, even if its operations are solid and profitable. In that case, the lower net income might not be too big an issue as long as the interest on the debt is not completely overwhelming.

Alternatively, if operating profit margins are low, it may mean the company is not really efficient in its day-to-day operations and has minimal latitude to lower prices if competition emerges.

What to Use for Valuation

Because there are so many different margins, it’s easy to get confused over which one to pay attention to. They are all valuable data points, but the one that matters most will depend on what question you are trying to answer.

👉 For Example

Consider the case of a quickly growing company. You expect profitability to be low due to very high investment in growth, but you need to know whether the low profitability (or losses) actually come from investing in growth.

In this case, looking at the gross profit margin will tell you about the real profitability of the company’s core business.

If the company sells a product for less money than it costs to produce or acquire it, even without taking fixed costs into account, this is a bad sign, and the company will need to make immediate changes.

Another example is a company laden with debt. Interest expenses will depress its net income or turn it negative. You might want to check the operating profit margin. It will tell you if the core business – without interest expenses – is profitable. It will give a realistic perspective on the company’s ability to service that debt and on how profitable the company is likely to be once the debt is paid.

Another use for margins is to use it to judge the competitive advantage of the company. High-quality companies tend to have higher margins than their competitors, reflecting more efficient operations, a higher sale price, an advantage on costs, etc.

What are Good Margins?

Margins can be used to compare different companies, but you need to know that each industry has different average margins. Software companies have low fixed costs so they will have higher net profit margins. Heavy industries need much more investment in inventories, factories, etc., so their net profit margins will be lower, even with good gross margins.

Industries like discount retail compete almost entirely on price and have minimal moats, so they typically have very low margins.

👉 Wal-Mart, for example, has had a net margin under 4% continuously since 2010.

The more difference there is between the gross and the net profit margin, the more attention should be given to CAPEX spending, as it often reflects the need for massive fixed costs, like factories or real estate.

The table below shows some selected industries and their average gross and net margins. As you can see, margins vary greatly between sectors and explain why some sectors are trading permanently at higher multiples of their revenues. $1 of sales in software is not the same as $1 of sales in a restaurant.

Margins: the Red Flags

Here are a few warning signs that come up when analyzing margins:

Negative gross profit margin: if the company loses money each time it sells, this is a big issue. Growth companies might claim that with scale, they will turn profitable. But this is unlikely to be true if gross margins are negative, as economies of scale are mostly from spreading fixed costs over more sales. Selling $1 for 90c and scaling up sales is a fast road to bankruptcy: the more you sell, the more you lose.
Margins below the industry or competitor average: underperforming companies might have management issues, higher costs, lower quality products, or high levels of competition. Margins lower than those of immediate competitors are also a risk, as the competitors could cut prices until the company you are analyzing is unable to stay afloat.
Good operating profit margin but negative net margin: This could indicate very high interest costs and an unsustainable amount of debt. Checking the balance sheet and the maturity profile of the debt is then important. When interest rates are rising the ability of a company to refinance or roll over the debt could be compromised.
Declining margins: if, over the last few years, margins have consistently declined, you need to find the reason. Is the industry in a downturn? If so, is it a cyclical trend or a long-term trend? Are new competitors entering the markets and hurting incumbents’ profits? Are inputs like energy, workers’ salaries, or raw materials increasing costs?
Sudden changes in profit margins: these usually warrant a closer look. Are margins changing due to changes in operations? An external factor that might not last (like, for example, a pandemic or an energy crisis)? Any radical departure from previous margin levels is more likely than not to revert to the mean. So if the company stock prices have fluctuated along the margins, it might be a good sign that it’s time to buy or sell.

Ideally, you’d look for consistent or gradually increasing margins that are equal to or better than immediate competitors and sector averages.

Conclusion

Margins are not the most exciting thing to analyze in a company. New products, competitive positions, and growth prospects often get more attention. They still provide a key insight into a company’s operations and capacity to turn a profit.

Margins should not be treated as an absolute number, like “I only buy if margins are above X.”

Instead, they give insight into what valuation is reasonable for a company.

They also give us a view into the competitive position of a company, as well as its potential future.

Overall, margins are a powerful tool for implementing an investment strategy, especially if used for comparisons: with competitors, between industries, or from one year to the other.

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This article originally appeared on FinMasters.com: Understanding Profit Margins: Profit, Gross, and Net

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