Foolish Fundamentals: Margins

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Traditionally, margins represent the efficiency with which companies capture portions of sales dollars. But that focus is too narrow -- margins can provide much more information.

The traditional lens
Experienced investors can skip this part. But for the less-experienced folks, a few definitions are in order:

  • Gross margin equals gross profit divided by sales. It indicates how well management is using labor and materials to support the business.
  • Operating margin equals operating income divided by sales. This is one way to show how well management is running the business.
  • Net margin equals net income divided by sales. This is the bottom line, the amount of money left after all expenses are paid.

Margins look at how much a company gets from each sales dollar after accounting for certain expenses. But let's go deeper.

The fuel lens
You can think of gross margins as a company's fuel. Gross margins power the operating decisions that a company makes. Typically, higher gross margins give companies flexibility in their operating decisions -- a good thing to use when making comparisons among competitors. Below are 3M's (NYSE: MMM  ) historical margins.

Metric

2002

2003

2004

2005

2006

Gross Margin

48.7%

49.1%

50.2%

51.0%

49.7%

Operating Margin

19.9%

20.9%

22.9%

23.8%

23.2%

Net Margin

12.1%

13.2%

14.2%

14.7%

16.8%

All data courtesy of Capital IQ, a division of Standard & Poor's.

Philip Durell understands what these margins mean to 3M. When recommending 3M for The Motley Fool's Inside Value newsletter service, Philip broke down operating income growth and operating margins by business unit to show just how strong a company 3M is.

More importantly, Philip understands that those gross margins fuel 3M's world-renowned innovation engine. Without them, 3M would not enjoy its competitive advantages, nor create as much value as it does.

The power lens
Taking a page from evolutionary biology: The powerful survive and control the environment, while the efficient are relegated to their niches. Efficiency is important along the way, but power is required to survive and get stronger in the face of intense competition.

To steal from legendary value investor Bill Miller, Motley Fool Stock Advisor pick Amazon.com (Nasdaq: AMZN  ) offers a perfect example of this way of thinking. During Amazon's development, CEO Jeff Bezos kept gross margin percentages fairly flat, focusing on growing gross margin dollars instead.

Metric

2002

2003

2004

2005

2006

Gross Margin

25.2%

23.9%

23.1%

24.0%

22.9%

Gross Margin (millions)

$992.6

$1,257.0

$1,602.0

$2,039.0

$2,456.0

Operating Margin

4.5%

6.8%

7.1%

6.4%

4.6%

Net Margin

(3.8)%

0.7%

8.5%

4.2%

1.8%

All data courtesy of Capital IQ, a division of Standard & Poor's.

But there is risk in this model, too -- management risk. As an investor, you must have confidence that management can execute its plan to sacrifice near-term profitability for long-term value creation.

The psychology lens
Although this may seem like a stretch, margins can actually create powerful incentives for people.

Costco (Nasdaq: COST  ) caps its gross margin at 14% for most items and 15% for private-label products for two reasons: to attract customers and keep them shopping in its stores, and to align the behaviors of all of its employees toward serving customers and controlling costs.

Tom Gardner recognized this strategy when he recommended Costco for Stock Advisor. As a Costco customer, Tom knows he's getting a great price. And Costco employees know that to create value, they have to serve customers as well and as cheaply as possible.

From the numbers below, we see that gross margin is low, which brings in lots of new customers and keeps membership renewal rates around 85%. And excellent cost control generates significant amounts of free cash flow over time.

Metric

2002

2003

2004

2005

2006

Gross Margin

12.3%

12.5%

12.5%

12.5%

12.3%

Cash from Ops. (millions)

$1,018.2

$1,507.2

$2,096.3

$1,776.0

$1,827.3

Capital Expend. (millions)

$1,038.6

$810.7

$705.6

$995.4

$1,212.6

Free Cash Flow* (millions)

($20.4)

$696.5

$1,390.7

$780.6

$614.7

*Free cash flow equals cash from operations minus capital spending.
All data courtesy of Capital IQ, a division of Standard & Poor's.

Costco's gross margin strategy is the glue that binds the employees to the customers, creating plenty of value.

Margins are important, but how you use margin information is more important to your investing success. Don't stay on the surface when analyzing margins. Your portfolio will thank you for it later.


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