How to evaluate corporate profit margins
Beginner Stock Market Investing, Online Stock Market Investing, Stock Market Investing Advice, Stock Market Investing Strategies
Every company is in business to make money consistently and efficiently with the objective of enriching its shareholders either through dividends or through capital growth or both. Naturally, the key to this objective is profitability and the more profitable than the company, the better its ability to pay dividends and the higher will be its stock price. It is therefore important for you to be able to analyze the profit margins of any company to determine how much it can generate and how these earnings are utilized. The process of analysis will also give you a valuable insight into what makes a company tick.
Most investors tend to only look at the bottom line of the company and rely on net earnings alone to judge the profitability of the company. As you can see, the process is a lot more complicated and relying just on net earnings can sometimes lead you to the wrong conclusions. The use of profit margin ratios, on the other hand, can give you a much better idea of the efficiency of managing the operations and the caliber of the management team. These ratios are calculated on the basis of neither assets or liabilities nor indeed the net worth. These ratios focus instead on sales or net revenues and how much profit the company is able to squeeze out of these inflows. Profit margin ratios are calculated in relationship to the sales and provide a basis for comparison with other companies as well. Net earnings expressed in absolute terms do not lend themselves well to any form of competitive analysis.
To illustrate, let us take the example of two different companies. Company A reports net earnings of $50 million on revenues of $500 million while Company B. reports net earnings of $75 million on revenues of $1 billion. On the face of it, Company B makes a higher profit than Company A. However, if you calculate the profit ratios, it works out to 10 percent for Company A and only 7.5 percent for Company B. In other words, Company A is more profitable because it earns $.10 for every sales dollar against 7.5 cents for Company B. This is a fact that that is not apparent when you compare net earnings in absolute terms.
There are three important profit margin ratios:
-The gross profit margin measures the profitability of a company in terms of the cost of goods sold. In other words, it measures how efficiently the company uses the sources such as raw materials and labor in the process of production. Naturally, companies with a high gross profit margin will have plenty of money left over to be spent on other business aspects such as brand building or research and development. A fall in the gross profit margin because of the enhanced materials and labor costs could be a cause of concern unless the cost escalation can be passed on to the customer.
-The operating profit margin is measured by comparing operating profit [earnings before interest and taxes] to the total revenues. The ratio measures how the company is able to control all its operating costs.
-The net profit margin is the profit after all costs including interest and taxes and is probably the single measure that reflects what the company generates for its shareholders.
Tags: Investing, profit margins, stock evaluation, Stock Market, Stock Market Investing, stocks