Pursuing Profits? Meet Margins!

Here at the Fool, we tend to sling around a lot of references to gross, operating, and net margins. If you're tired of nodding your head and pretending like you understand what any of that confusing jargon means, take heart. We've got a quick, easy, and thoroughly painless breakdown of what margins are -- and why they matter to your investments.

What are margins?
A company starts with revenue -- the total amount of money it brings in for selling its goods and/or services. On the way down its income statement, it subtracts various costs from that revenue. Margins are the percentages of profit left behind after you take out different sets of costs at three places on the income statement. We'll quickly go through each of the three types of margins, and what each one measures.

Gross margin
Just under revenue (aka "sales") on the income statement, you'll find "cost of goods sold" (aka "cost of sales" or COGS). This latter figure represents how much it cost the company to produce the goods or services it ultimately sold to get its revenue. Over the last 12 months, IBM (NYSE: IBM  ) posted a COGS of $56 billion, against $101 billion in revenue. Subtract COGS from revenue, and you get a gross profit of $45 billion.

How much of IBM's total sales make their way into that gross profit? That's what the gross margin tells you. Dividing the gross profit of $45 billion by IBM's revenue of $101 billion yields a gross margin of 44.6%. Not too shabby, especially compared to rival Hewlett-Packard's (NYSE: HPQ  ) recent gross margin of roughly 23.4%. A gross margin can tell you how well a company's competing against its closest rivals.

Operating margin
There's more to running a business than simply the cost of the raw materials used to make your products. You've got support staff salaries, rent, utility bills, and countless other expenses to account for. Subtract these figures from the gross profit, and you're left with the operating profit -- $17.7 billion, in IBM's case. (Wow, that's a lot of paper clips and coffee filters!)

Divide this figure by revenue, and you'll get the operating margin -- 17.6% for IBM, in our example. While the gross margin helps you stack up a company's performance against that of its competitors, operating margin lets you see how well a company's holding up against its own previous results. A lower operating margin year over year may mean a company's becoming less efficient in its internal operations (or possibly that Bob in accounting is making way too many free photocopies on the company's dime).

Net margin
Finally, after items such as taxes and interest payments are accounted for, you're left with net profit (more commonly known as net income), near the bottom of the statement. Dividing IBM's net profit of $12.3 million by its revenue yields a net profit margin of 12.2%. This number reflects how much of every dollar of sales a company keeps as profit -- the rock-bottom fundamental view of its fiscal strength.

What margins can tell you
Running several simple tests with margins can tell you a lot about a company and its competitors.

First, compare a company's margins with those from previous years. Rising margins indicate that a company's increasing its efficiency and profitability.

Next, check out the margins of the company's competitors. Is the company you're interested in more efficient than its peers? Look for significant changes in revenue, expenses, and costs of goods sold.

Finally, note that profit margins can vary widely. First Solar's (Nasdaq: FSLR  ) net margins top 30%, while companies like Western Digital (NYSE: WDC  ) and Unilever (NYSE: UL  ) typically clock in around 10%. Companies can do phenomenally well despite low margins, provided they compensate by selling huge volumes of services or goods.

The differences between a company's gross, operating, and net margins can also tell you a lot. In the software industry, for example, many companies sport sky-high gross margins of 80% or more, but much lower (though still high) net margins of 20% to 30%. That difference suggests that while it's cheap to physically create and distribute the software, the company's probably spending far more money on research and development, marketing, administration, and highly caffeinated sodas for the programmers' mini-fridges.

Put margins to work for you
If you're trying to figure out which companies deserve a berth in your portfolio, a look at profit margins might be a big help -- especially if you can unearth companies whose margins are on the rise.

I recently screened for large-cap companies with net profit margins greater than 10%, with at least five consecutive annual increases in those figures. Here are a few of the stocks that turned up:

Company

CAPS Rating (Out of 5)

Net Profit Margin

PotashCorp (NYSE: POT  )

****

38%

IBM

***

12%

Union Pacific (NYSE: UNP  )

****

13%

Data: MSNMoney.com, CAPS.Fool.com.

Keeping an eye on margins can help you find better, stronger, more profitable companies -- and increase the profitability of your own portfolio in the process.

More margin mojo:

Need a bit more help finding great stock ideas? Try our Motley Fool Stock Advisor newsletter. Its analysts look closely at profit margins and other important measures to find the best stocks in the market. A free trial will give you 30 days of full access to all recommendations and past issues.

Longtime Fool contributor Selena Maranjian doesn't own shares of the companies mentioned. Unilever is a Motley Fool Income Investor pick. The Motley Fool is Fools writing for Fools.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 29, 2009, at 11:27 AM, spokanimal wrote:

    Probably should have mentioned EBITDA since, in a world of different margins, it's becoming the standard measure of profitablity. That's especially true in these times of credit problems given that so many bank loans have covenants that define default by a company's debt-to EBITDA ratio.

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