The term “profit margin” refers to the percent of profit a company makes from each dollar of revenue it generates. In other words, profit margin measures how much out of every dollar of sales a company actually keeps in earnings. The calculation is fairly straightforward. A company’s profit is simply total sales minus total operating expenses. A company that generates $100 million in sales and keeps $20 million in profits is said to enjoy a profit margin of 20% ($20 million of profit / $100 million of sales).
What traders look for
The profit margin provides an indication of how efficiently a company runs its operations. Clearly, the higher the profit margin, the better. In essence, profit margin is greatest for companies that maximize their sales revenues and minimize their operating expenses.
This value is especially useful when comparing different companies in the same industry group. For example, if one auto manufacturer, has a profit margin of 2% and another a profit margin of 5%, this provides a clear clue that the latter is running its operations more efficiently and is squeezing more profit out of each dollar of revenue.
Another useful way to analyze profit margin is to compare the current annual profit margin for a given company to its own average annual profit margin over the past 5 to 10 years to see if the company is able to maintain a consistent rate of profit margin.
What traders look out for
One way that a company can maximize its profit margin is to reduce its operating expenses. That being said, there can be times when a company’s management will get so carried away with cutting costs that they will actually hurt the company’s ability to function efficiently. For example, this can happen by cutting too many workers which can affect the company’s ability to produce enough product in a timely manner, or by reducing inventory to a level that fails to meet current demand, which can result in lost sales.
It is possible for a company to sow the seeds of its own future troubles by attempting to maximize its profit margin via an aggressive reduction in operating costs.
It should be noted that one company with a higher profit margin may not necessarily be a better investment than another company with a lower profit margin. Many other factors such as sales and earnings growth, as well as value factors such as price/earnings and price/book value ratios may result in one stock with a higher profit margin soaring to an overvalued price, while the stock of a company with a lower profit margin might be undervalued.
In the long run, companies that operate most efficiently have the greater potential to grow their earnings at a higher rate. Profit margin represents an excellent gauge of company efficiency.