With the holiday season in full swing, millions of shoppers desperately want to know if they're getting the best deal possible. What many of them will never realize is that at least when it comes to figuring out how much true value you're getting from the products you buy, companies tell their investors every quarter just how successful they've been in extracting as much money as possible from buyers.
The $7 cup of coffee and you
Last week, Starbucks (NASDAQ:SBUX) started selling a $7 cup of coffee in several locations across the country. The reason: The new offering uses expensive Costa Rica Finca Palmiera beans that come from rare Gesha trees. Yet as a MarketWatch report noted, even with all that exclusivity, the extra $1 to $1.30 per cup that the new coffee will cost Starbucks is far less than the $4 to $5 more that the company is selling the coffee for.
Starbucks also isn't missing the chance to sell to home brewers too, selling beans at $40 per half-pound. That gives those who make coffee at home the chance to get their ultra-premium fix at less than half the price -- but it's still way more than you'd pay for a standard blend.
Yet no one who's familiar with Starbucks' financials should be at all surprised by the company's success. All along, Starbucks' business has been founded on the idea that people are willing to pay up for their java, leading to net margins of more than 10% -- very high for the restaurant business. In fact, striving for higher margin is a big part of what Starbucks is trying to do with its purchase of Teavana (NYSE: TEA).
What margins tell you
The definition of profit margin is very simple: Take the net income that's left after paying all of a company's expenses, and divide it by the company's gross revenue. In other words, margins tell you how much of every dollar is left for owners as profit after paying all the costs involved in doing business.
Companies don't have to have huge profit margins in order to be successful. Costco, for instance, has razor-thin margins on the goods it sells. But it's able to make substantial profits for two reasons: First, it sells a whole lot of merchandise, and second, it charges membership fees to its customers, which represent pure profit for the company.
All other things being equal, though, big margins are a nice thing for a company to have. They give companies room to cut prices when necessary without jeopardizing their profitability, which can be immensely valuable when fighting competitors.
Prestige at a price
Premium coffee isn't the only luxury item that draws healthy margins. When you look at perceived luxury items, you'll often find these high markups accompanying them. Tiffany (NYSE:TIF), for instance, has historically featured high margins, as its focus is on producing high-quality jewelry and other luxury items that have brand appeal as well as intrinsic value. Recently, falling margins have jeopardized the stock.
lululemon athletica (NASDAQ:LULU) is in what many would think was a pedestrian business: making clothing. Yet its premium focus, its niche targeting yoga practitioners, and its drive toward attracting customer loyalty have allowed lululemon to reap better than 18% profit margins overall -- not bad for a pair of yoga pants. Coach (NYSE:TPR) weighs in with even better margins of 21%, again not by selling anything more revolutionary than a handbag, but because it has convinced its customers that its handbag is the one they really need.
Shopping vs. investing
As a shopper, when you see a company with such high margins, you should think twice before you pay up for their products. High margins leave room for competitors to undercut on price -- if they can match up on quality.
As an investor, though, you should look closely at businesses that get their customers to pay so much for their goods. When demand is so strong, rationality often goes out the window, and smart businesses cash in on those trends as long as the opportunity's there.