The Advantage of High Profit Margins

There are many factors to examine when you're thinking of investing in a company. From my Foolish colleagues, you can learn about how important insider ownership and return on equity can be in a winning stock. Also, dominance in a growing industry and high corporate values play a part in one colleague's best stock-picking strategy.

To add a thought of my own, here's a relatively simple factor that you should understand if you're going to pick stocks on your own: net profit margin. You can learn the basics about it here, but, essentially, margins tell you how much of every dollar of revenue ends up as profit on the bottom line.

After you feel comfortable understanding what net profit margin is, play around with it a little -- do some screening and see what you can discern about companies that interest you. Here -- check out some of the companies I got when I screened for large caps with net margins above 20%:

Company

Net profit margin

Oracle (Nasdaq: ORCL  )

24%

Paychex (Nasdaq: PAYX  )

26%

Schwab (Nasdaq: SCHW  )

23%

Coach (NYSE: COH  )

21%

Data: Yahoo! Finance.

Remember that these are high numbers -- many industries, such as retailers and airlines, persistently sport very low margins. Wal-Mart's (NYSE: WMT  ) margin was recently 3.3%, while Southwest Airlines (NYSE: LUV  ) clocked in at 0.5%, and Whirlpool's (NYSE: WHR  ) was 2.2%. Low margins don't automatically make a stock a bad investment, though, as a company that can pair low margins with high volume can bring a pleasant result -- witness Wal-Mart's annual net income topping $13 billion.

What high margins mean
High margins, though, reflect corporate strengths -- in business models and powerful brands, for example. Most handbag makers won't be able to keep a third of every dollar they take in as profit, but Coach can because of its high-status brand name.

Also, companies whose costs are largely fixed benefit from growing their customer base. Oracle, for instance, can enjoy hefty margins from its business model because once it develops software to sell, each additional sale doesn't cost it much more. The more it sells, the greater its profit margin will be. Paychex, similarly, has its systems ready to assist companies with their payroll and other needs, while Schwab has its trading platforms and account management systems in place. For many businesses, adding more customers is the key to increasing profit margins.

When companies have high margins, they also have cushions. They can afford to lower prices if they need to and to put pressure on competitors. They have competitive advantages. So, consider it a big plus when a company you're looking at sports a fat net margin.

For more on finding the best values in the market, read:

Profit margins are one of the measures our analysts examine when seeking stocks to recommend to you in our Motley Fool Inside Value newsletter. Paychex and Wal-Mart are two of its current recommendations. Try it for free and you'll have access to all past issues and all stock picks.

Longtime Fool contributor Selena Maranjian owns shares of Paychex and Wal-Mart. Coach and Charles Schwab are Motley Fool Stock Advisor recommendations. Paychex is a Motley Fool Income Investor recommendation. Try our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.


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