Ever wondered whether you should avoid companies with low profit margins? In general, higher margins are better than lower margins. But don't be like some investors, not even considering companies with lower margins. Look at the big picture, including factors such as inventory.
A glance at inventory turnover can reveal some attractive companies with low margins. (Inventory turnover is represented by the cost of goods sold divided by the average dollar value of inventory.) Imagine two companies: The Acme Piano Co. (ticker: GRAND) has a whopping profit margin of 28%, while the Krazy Kazoo Co. (ticker: BZZZ) has only a 2% margin. If Acme only sells three pianos a year while Krazy sells out of kazoos each week, Krazy may well be the better buy, generating more cash in total than Acme.
Some industries, such as software, typically have high profit margins. Discount stores and supermarkets have very low profit margins -- but if they turn over inventory fast enough, they might still be decent investments.
Look at Wal-Mart (NYSE:WMT). Its net profit margin is a paltry 3% or so -- much, much lower than Microsoft's (NASDAQ:MSFT) 33% and lower even than that of aluminum maker Alcoa (NYSE:AA), which sports a profit margin of about 4%. Despite the low margin, Wal-Mart has clearly been an amazingly profitable investment for many years now -- and that's largely due to turnover. What it lacks in profit margin it more than makes up for with volume.
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