Next on the list of Foolish 8 requirements for good small companies is a net profit margin of at least 7%. To make sure everyone is on the same page, net profit margins refer to the percentage of sales that wind up as earnings on a company's income statement during a particular accounting period. In short, the net profit margin is a quick and easy way to compare a business' bottom line to its top line.

We won't broach the enormous subject of exactly what kinds of accounting items fall in between a firm's top line and bottom line and thus lead to the creation of the net profit margin animal in the first place. Suffice it to say, there are a lot of income statement particulars that an investor should be aware of and they are all derived through a number of accounting conventions and norms.

Just like any other financial number that ostensibly adheres to the business reporting cheesecloth known as Generally Accepting Accounting Principles (GAAP), the net profit margin figure reported by a company should not be accepted out of hand by investors as some type of absolute truth. Historical instances abound where all kinds of financial figures reported by companies -- including profit margins -- have turned out to be pure fictions.

The responsibility for verifying a company's financial figures falls squarely on the shoulders of the individual investor, who should at the very least have a basic familiarity with the rudiments of accounting. In short, if you are considering a long-term investment in a company without first having a decent grounding yourself in accountancy, I have only two words of advice: index fund.

Turning away from the broader issuer of accounting nuances and getting back to the issue at hand, it turns out that a 7% net profit margin is a pretty decent level of profitability to require from a company, small or otherwise. Ending up with just 7% of total sales after tallying up all costs and expenses during a period may not sound like much of a hurdle, but a glance at the data seems to show otherwise.

According to, less than one out of four U.S. publicly traded companies can claim a net profit margin north of 7% over the past year. By that measure alone, this Foolish 8 requirement appears to be a fairly good screen for identifying highly profitable companies. If you graph all companies as falling somewhere along a basic bell curve-shaped distribution, those that can manage to report just 7% net profits margins will be found firmly to the right of the statistical mean.

Here are some other data to chew on, which some investors may also find surprising:

Net Profit Margins

Average net profit margin for S&P 500 companies ...... 7.0%
Average net profit margin for all Nasdaq companies ... 3.1%
Sources: Lehman Brothers and Nasdaq market data, based on end of Q2 figures for the S&P 500 and September figures for Nasdaq companies.

As the data above illustrate, high net profit margins are hard to come by. This appears to especially be the case for small companies, the large majority of which are traded on the Nasdaq market. To make it through the Foolish 8 screening process, a small company will need to show a net profit margin that is more than twice that of the average Nasdaq-listed company and roughly equal to the average S&P 500 company. In sum, the 7% net profit margin filter will end up yielding many if not all of the most profitable small companies out there.

Finally, it must be stated that the net profit margin, despite the term itself, cannot always be viewed as the final arbiter of a company's underlying profitability. Firms can generate high levels of earnings -- or more precisely operating cash flows, to use another yardstick that will be discussed at length later -- despite very low margins. In most cases, this is accomplished by tweaking aspects of the business that are reflected on the balance sheet rather than on the income statement.

Companies that exhibit both low margins and high cash flows are rare, especially in the small company world. However, such companies do exist, typically in cash-and-carry businesses such as retail where there are large benefits to be had from smart asset management. Further, the most successful examples of the low margin/high cash model also tend to have large-scale positions in their markets. The low margin models of Wal-Mart (NYSE: WMT) and Dell Computer (Nasdaq: DELL) may have worked nonetheless when the firms were small and just starting out, but they worked dramatically better over time as the two companies expanded their respective market shares and evolved into dominant firms.

By their very nature, small companies are generally not able to benefit from traditional scale economics. Cash flows and bottom line earnings will need to sprout from another advantage, most likely from operational excellence in a specific business niche. That's where the net profit margin really comes in handy. For small companies, the net profit margin is one of the most important levers for determining bottom line profit generation. With that in mind, this simple measure is a tool every small company investor should understand and make a part of their stock selection strategy.

[Motley Fool Research's Industry Focus 2001 features more on Foolish 8 small-cap stocks.]

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