Profit Margin Analysis Is Key to Identifying Quality, Part 4

This is the final installment in an article on profit margin analysis from the SmallCap Informer newsletter.

Digger Deeper into Margins
As with any trend-based analysis of company fundamentals, there can be a number of factors that can affect performance. When an anomaly is spotted, possible explanations should be sought from further research into the company’s SEC filings, press releases, public disclosures, and other information.

Some of the external factors that can impact a company’s margins, both positively and negatively, include:

• Labor costs
• Raw material costs
• Energy costs
• General economic conditions
• Marketing costs
• Weather-related disruptions
• Competition

This isn’t to say that companies get a pass anytime one of these issues affect a company’s business, but they might help understand why a company might see its margins fall into a particular period and then recover. Intelligent management teams can certainly make efforts to mitigate the effects of many of these factors by hedging fuel contracts, negotiating long-term worker contracts or sourcing materials from a diverse group of suppliers.

Not even the best-run companies in economically-sensitive industries can fully avoid the impact of a recession on their businesses, though they may be able to take steps to minimize the downturn or otherwise act in a defensive manner.

Margins may also vary differently amongst companies in the same industry group. Coca-Cola and PepsiCo are both generally considered to be in the beverages industry, but PepsiCo generates a significant amount of revenue and profit from its non-beverage (and lower-margin) operations, Frito-Lay and Quaker Foods. This makes the comparison between these two companies a bit less meaningful.

When it comes to evaluating smaller companies, a dose of proper perspective should be applied to the process. A small, growing business may choose to give up some profits now in return for a greater market share or potential for increased returns in the future. As such, their margins may pale when compared to more established competitors. In time, though, these smaller companies may turn out to be the “next big thing” and stand up well in contrast to the former giants in their field.

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