Profit Margin Analysis Is Key to Identifying Quality
One of the tests of quality that savvy investors utilize when studying a company is a review of its profit margins. This key figure can reveal much about the expertise of a company’s management team.
Profit is the money that’s left over after a company sells its products or services and pays all its costs of doing business. The profit margin (sometimes known as the net profit margin) is the percentage of a company’s profits compared with its sales. The higher the profit margin, the more the company is earning on each dollar of sales it makes to its customers.
A company’s operating margin compares a company’s operating income (earnings before interest and taxes, known as EBIT) to sales.
The gross proﬁt margin measures the money a company makes from the cost of goods sold (the expenses related to labor, raw materials and manufacturing). This figure measures how efﬁciently management uses labor and raw materials in the production process.
In this light, you can consider all the various profit margins as measures of management‘s ability to control costs. No matter how skilled a company’s leaders may be at selling, if they don’t make a profit, those sales are not gaining any ground for the company. Lowering prices to the point where a business loses money is not an effective long-term strategy.
One element that is not always in management’s control is the corporate income tax rate paid by the firm. Newer companies may have run up years of losses and associated tax credits, thus lowering their tax rate (even to zero) for several years until the credits run out. Other businesses may have found opportunities to relocate their headquarters offshore or taken advantage of tax law loopholes to reduce their tax burden (though we don’t consider these last few tactics as a measure of management expertise).
For the above reasons, we prefer to consider the pre-tax profit margins of companies. By considering the percentage of profits earned on sales before taxes are paid, we can place similar companies on an even footing and make more informed comparisons.
There are a number of ways that investors can dissect a company’s pre-tax margins to expose a company’s strengths or weaknesses.
Reviewing Margin Trends
On the Stock Selection Guide, the 10-year history of a company’s pre-tax margins is displayed, with particular emphasis on the figures from the last five years. The intent is to provide insight into the trend of margins over time, especially by comparing the average five-year profit margin to the value from the latest fiscal year.
Are the margins relatively stable? This is an indication of a well-run business.
Are the margins wildly erratic? This can be a sign of turmoil in a company’s operations.
Are the margins declining? Management may not be doing a good job handling increases in raw material costs, labor rates, marketing expenses, or be facing competition that’s driving down prices.
Are the margins increasing? Very occasionally, companies can be found that have hit their stride and are maximizing their resources particularly well. Although every company aims to attain “economies of scale” as they grow, it’s not every business that can actually achieve these gains in productivity and expansion of their margins.
Industry & Peer Comparisons
Analyzing the trend of margins is critical, but it’s not the only measurement that should be taken. A company’s margins can be compared to its peers and industry group, as well, illuminating how the company stacks up to competitors.
But it’s imperative to note that pre-tax margins vary considerably by industry. Some industries, particularly those with very competitive business climates, are at the end of multistage supply chains or deal with highly perishable goods typically sport very low margins.
Digger Deeper into Margins
As with any trend-based analysis of company fundamentals, there can be a number of factors that can affect performance. When an anomaly is spotted, possible explanations should be sought from further research into the company’s SEC filings, press releases, public disclosures, and other information.
Some of the external factors that can impact a company’s margins, both positively and negatively, include:
• Labor costs
• Raw material costs
• Energy costs
• General economic conditions
• Marketing costs
• Weather-related disruptions
This isn’t to say that companies get a pass anytime one of these issues affect a company’s business, but they might help understand why a company might see its margins fall into a particular period and then recover. Intelligent management teams can certainly make efforts to mitigate the effects of many of these factors by hedging fuel contracts, negotiating long-term worker contracts or sourcing materials from a diverse group of suppliers.
Not even the best-run companies in economically-sensitive industries can fully avoid the impact of a recession on their businesses, though they may be able to take steps to minimize the downturn or otherwise act in a defensive manner.
Margins may also vary differently amongst companies in the same industry group. Coca-Cola and PepsiCo are both generally considered to be in the beverages industry, but PepsiCo generates a significant amount of revenue and profit from its non-beverage (and lower-margin) operations, Frito-Lay and Quaker Foods. This makes the comparison between these two companies a bit less meaningful.
When it comes to evaluating smaller companies, a dose of proper perspective should be applied to the process. A small, growing business may choose to give up some profits now in return for a greater market share or potential for increased returns in the future. As such, their margins may pale when compared to more established competitors. In time, though, these smaller companies may turn out to be the “next big thing” and stand up well in contrast to the former giants in their field.