Profit Margins Deserve a Critical Eye
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As a rule, you'd like to see a company in which you're invested to have high profit margins. The higher, the better!
When a company is in business, the difference between its costs and its selling price is their profit margin. And if a company has a competitive advantage, that means the company has the ability to reasonably raise the prices of its products or services without adversely affecting demand. High profit margins are a sure indication of a competitive advantage being in place.
Customers are willing to pay higher prices for brand named, high-quality, and unique products/ services that they are accustomed to! As prices increase versus the costs to produce the goods, the profit margin increases.
Formula - Net Profit Margin
In the formula above, "cost" is total operating expenses. The formula for Gross Profit Margin is similarly set up. Just divide Gross Profit (Revenue - Cost of Goods Sold) by Revenue. Both Gross Profit Margin and Net Profit Margin are deserving of a critical eye. It helps to determine how well a company is managing its operating expenses... or not.
If you're researching a company, you generally want to look for 3 things when it comes to profit margins:
- Profit margins are higher than its competitors.
- Consistency with profit margins. How are margins trending over time?
- Inventory turnover - how fast are they selling their products/services?
Essentially, companies make money in two ways: by having the highest profit margins possible and/or by having the highest inventory turnover possible. The ideal company in which to invest possesses both, high profit margins and high inventory turnover.
Most providers of professional services, like consulting firms or law firms, tend to have high profit margins. They have differentiated products based on the intellectual property of the associates on their payroll. Many such companies with reputable brands are able to charge a premium with high margins to the customers they serve. They may have few projects (meaning low inventory turnover), but the prices commanded for their services are high profit margin services.
In contrast, retailers tend to have low profit margins. More often than not, there are other retail establishments selling the same products to retail customers. And by the time their products get through the supply-chain, a lot of the costs incurred have already made up a large portion of the going rates for such products. They tack on a small amount (e.g. 1% - 3% of the cost) as the profit margin. But they end up selling a high volume of products (high inventory turnover). The higher the inventory turnover, the better in this case.
So as a rule, if you're evaluating a company as an investment prospect, you'll want to see high profit margins - the highest margins as compares to competitors, with consistency over time.
And/or you'll want to see the highest inventory turnover possible, which means they're selling a lot!
Companies with High Profit Margins
Of course, if profit margins are high enough, then inventory turnover doesn't necessarily need to be high. Always compare vs competitors.
Companies with Low Profit Margins
Even if the company has generally low profit margins, you'll still want to see higher margins than direct competitors and high inventory turnover.
And, of course, whether a company has high profit margins or low profit margins, look for companies with a durable competitive advantage!