In "The Incredible Lightness of Part-Time Investing," we introduced financial ratio investing as a means to gain confidence in monitoring your investments over the long term. We described each of the four basic areas of modern financial analysis as answering a "big-picture" question as follows:
- Liquidity: Does the company have sufficient cash or other means to meet short-term obligations?
- Profitability: Is the company profitable during the period in question?
- Solvency: Can the company meet its long-term debt obligations?
- Activity: Is the company efficiently managing its assets and other resources?
Perhaps the trickiest of all the four areas is profitability. The mother of all profitability ratios is, of course, the profit margin ratio (also known as net profit margin, or simply "profit margin"). This ratio divides a company's net income by total revenue. While the profit margin ratio is one of the most accessible pieces of information available on a company, it's also one of the most difficult to use to your advantage: Just viewing last quarter's profit margin for any given corporation won't get you far.
The key to using the profit margin ratio successfully is to put some context around it -- that is, to combine it with other relevant information, preferably over a period of time. Because net profit margin is the final result after every possible cost and expense has taken a swipe at revenue, it's the metric that benefits most from pertinent accompanying information. Think of context as the circle of financial information that lets the profit margin blossom -- don't let profit margin be a social wallflower in your analysis! Following are just a few examples of the many ways you can contextualize the profit margin ratio:
- Profit margin versus the company's overall revenue trend.
- Profit margin relative to the company's industry.
- Profit margin within a trailing-12-month trend.
- The relationship between profit margin and cash flow.
- The relationship between gross margin and profit margin.
On a practical note, the YCharts data service provides many free "fundamental" charting options that allow you to combine different ratios and metrics over time, which can help you put contextual information into a visual format. Let's walk through an example together.
Taking the noise out of the Yahoo! investment decision
It's no secret to those who are rooting for Yahoo!'s (NASDAQ:YHOO) success that the company generates admirable profits. Let's look at the company's net profit margin on a quarterly basis for the past five years.
The spike in profit in the third quarter of 2012 is a one-time event related to a partial sale of the company's interest in the Alibaba Group. Outside of this, it's clear that the company reliably churns out a high profit margin, one that happens to outshine the profit margins at Google (NASDAQ:GOOGL), eBay, and Apple, to name a few profit margin stars. Now let's add a little context:
In the preceding visual, the central question surrounding Yahoo! gets distilled. While the company generates remarkable profits, it nevertheless stands at a critical juncture. If the revenue decline can be staunched, Yahoo! will probably prove a smart investment. At present it's valued at just 8.6 times trailing-12-month earnings. But if revenue continues its long-term implosion, an investor's capital could potentially be at risk. Of all the tasks CEO Marissa Mayer keeps on her to-do list in her Yahoo! Calendar app, you can bet these two are near the top: stabilize and expand revenue, and maintain those handsome margins.
Just for fun, let's look at the same profit margin metric relative to revenue at Mayer's corporate alma mater, Google:
In some ways, this is a rough inversion of Yahoo!'s chart. Google's net profit margins have charted a southerly course since 2010, primarily driven by softer pricing for its ads and continued losses from its Motorola mobile business. The company's compensating factor is the nosebleed ascent of its revenues, which are up nearly 165% over the past five years. Google trades at a multiple of earnings nearly three times greater than Yahoo!'s. A conclusion you can quickly draw here is that the market grasps that Google's heady top-line growth provides room to tweak profitability over time, and investors are willing to pay more for the relative security. The worry is much closer to home in Yahoo!'s case, where, despite sterling profits, the company is wrestling mightily to stem its sinking income.
Start forcing the profit margin to socialize today
When used thoughtfully and in context, the profit margin ratio can be the deciding factor when you're on the cusp of entering a position. It's also an indispensible metric in the quarterly checkups that should be part of your "Part-time Investing" strategy. In the next article of this series, we'll explore another power tool on the garage shelf of profitability measures, one that separates long-term stock market leaders from the also-rans: return on invested capital, or ROIC.
Fool contributor Asit Sharma has no position in any stocks mentioned. The Motley Fool recommends Apple, eBay, Google, and Yahoo! and owns shares of Apple, eBay, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.