One of the tests of quality that savvy investors utilize when studying a company is a review of its profit margins. This key figure can reveal much about the expertise of a company’s management team.
Profit is the money that’s left over after a company sells its products or services and pays all its costs of doing business. The profit margin (sometimes known as the net profit margin) is the percentage of a company’s profits compared with its sales. The higher the profit margin, the more the company is earning on each dollar of sales it makes to its customers.
A company’s operating margin compares a company’s operating income (earnings before interest and taxes, known as EBIT) to sales.
The gross profit margin measures the money a company makes from the cost of goods sold (the expenses related to labor, raw materials and manufacturing). This figure measures how efficiently management uses labor and raw materials in the production process.
In this light, you can consider all the various profit margins as measures of management‘s ability to control costs. No matter how skilled a company’s leaders may be at selling, if they don’t make a profit, those sales are not gaining any ground for the company. Lowering prices to the point where a business loses money is not an effective long-term strategy.
One element that is not always in management’s control is the corporate income tax rate paid by the firm. Newer companies may have run up years of losses and associated tax credits, thus lowering their tax rate (even to zero) for several years until the credits run out. Other businesses may have found opportunities to relocate their headquarters offshore or taken advantage of tax law loopholes to reduce their tax burden (though we don’t consider these last few tactics as a measure of management expertise).
For the above reasons, we prefer to consider the pre-tax profit margins of companies. By considering the percentage of profits earned on sales before taxes are paid, we can place similar companies on an even footing and make more informed comparisons.
There are a number of ways that investors can dissect a company’s pre-tax margins to expose a company’s strengths or weaknesses.
Next Installment: Reviewing Margin Trends
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