Welcome to Part 5 of our series on the craft of Rule Maker investing. So far, we've reviewed our philosophical underpinnings of the Rule Maker strategy and are slowly working our way through the six financial benchmarks that we require of the companies in our portfolio.

Today, the talk turns to net profit margins. I'll discuss the importance of net margins shortly, but before I do, let's answer the most basic question first: what are net margins?

To answer this, we first have to know what net income is. Net income is simply what's left over in profit after all costs have been deducted from the sale of a company's products and services. Let's take a look at the latest income statement from Cisco's (Nasdaq: CSCO) Q2 2001 earnings release. (Go ahead and open that link in a separate window, scroll down to the first table of numbers, which is the income statement, and follow along.) The top line is always revenues, and in this case it is $6.748 billion (not bad for 90 days work, eh?).  Now, at the very bottom of the income statement is a line item called net income (some companies call it net profit). In Cisco's case, that number is $1.33 billion (on a pro forma basis). That's the profit that resulted from all those sales.

But where does that number come from? Well, in between sales revenue and net income on the income statement is a bunch of stuff -- most of that stuff being expenses. If the company sells an actual physical product (as opposed to performing a service), there will be a cost to make that product. As you learned from Todd in Friday's article, Cisco's direct cost of producing all those routers and products was $2.581 billion, leaving $4.167 billion in gross profit. But that's not what the company gets to keep -- there are a lot of other costs of doing business besides just building the products or providing the services.

First of all, there are operating expenses. Cisco breaks out its operating expenses into three categories: research and development, sales and marketing, and general and administrative. In the most recent quarter, Cisco's cost for these three combined categories was $2.594 billion. If we subtract this from the $4.167 billion Cisco had in gross profit, we can see that the company is now down to $1.573 billion. But we aren't done yet. There are two other things to consider. The first is interest expense (if the company has debt to pay back), and the second is that universal economic burden, taxes (unless, of course, your name is Marc Rich).

Cisco, like most true Rule Makers (by virtue of having more cash than debt) doesn't have interest expense -- rather, it makes money on all the cash it's sitting on. In fact, Cisco earned $275 million in interest income in the latest quarter, bringing profit before taxes to $1.848 billion. After paying $518 million in taxes, Cisco has $1.33 billion left as net income.

Now that you know what net income is, let's calculate Cisco's net profit margin.  Net profit margin is simply the net income as a percentage of sales. Here's the formula:

Net Margin = Net Income / Sales

Let's work through this simple and important calculation for Cisco's second quarter:

Sales:         $6.748 billion 
Net income:    $1.330 billion 

Pulling out my trusty calculator, I divide 1.33 by 6.748. The result is 0.197, or 19.7%. In other words, for every dollar of Cisco's network equipment sales, 19.7 cents goes right in the bank as profit. That compares to our Rule Maker benchmark of 10%, or 10 cents on every dollar. Not bad, eh? 

Why net profit margins are important
OK, now that you know what net profit margin is and how to calculate it, let's talk about why it's important. As Rule Maker investors, we aren't interested in just any old company -- we want to find companies that have true staying power. One of the common characteristics of the companies in our Rule Maker portfolio is that they all have some competitive advantage that allows them to price their products high enough to guarantee large profits. We'll be talking more about competitive advantages in the upcoming Rule Maker 2001 online seminar, but let me say this: Even if you cannot identify a strong competitive advantage, the mere fact that a company has a high profit margin is strong evidence that the company also has one or more advantages over its competition.

Cisco, Microsoft, Pfizer, Coca-Cola, and American Express each have a fundamental advantage over their competition that enables them to achieve high profits. In addition, companies that have high net profit margins have much more cushion to protect them during the hard times -- hard times that can wipe out the entire profits of a company with low profit margins. In fact, true Rule Makers typically use their profit margin advantage to aggressively take market share or improve their competitive position even further during the hard times -- making them even stronger when things turn up again.

Yep, many of the Rule Makers who are currently being pummeled on the open market are actually the companies that have the best shot of thriving when the economy turns upward again. There's a lot of opportunity out there among beaten-down Rule Makers. In fact, one of the goodies you'll receive in our upcoming seminar, The Art of Rule Maker, is a report on the Rule Maker managers' top 25 investment ideas.

We'll rank these ideas #1 through #25 based on each company's long-term Rule Maker strength and investment potential. During the seminar, you'll receive the education to really get the most out of the Top 25 report. The seminar lessons will teach you the four most critical aspects of qualitative Rule Maker investing analysis: sustainable competitive advantage, great management, expanding possibilities, and a reasonable purchase price. With those lessons under your belt, you'll be ready to put some of our Top 25 Rule Maker investment ideas into action. I can speak for my fellow Rule Maker managers and say we see a lot of great opportunities amidst the carnage. We hope you'll join us for the seminar!

Part 6: Lovely, Lovely Cash �

Zeke Ashton is a co-manager of the Rule Maker portfolio. He owns shares of two of the companies mentioned in this article: Cisco and American Express. (He's still waiting for the upturn.) You can see the rest of his portfolio in his online profile. The Motley Fool is investors writing for investors.