The profit margin tells you how much profit a company makes for every $1 it generates in revenue. For example, if the net profit margin is 30%, company makes $0.30 for every dollar generated in revenue. It is calculated by using:
(Net income ÷ Revenue) * 100%
Personally, I look for net profit margins to be higher than 20% (exceptions made for certain companies for underlying reasons).
Always compare the net profit margin with that of similar companies. Comparing margins with peer group provides an excellent way of judging performance of the management team. If the margin of a particular company is always consistently higher than those of similar companies operating in the same sector, then as a business and as a management, the company has found a winning formula. The higher-margin business has built up a dominant market position, effective way of generating high margins and a culture that enables it to do very well in the long run.
What has been driving the company’s margins?
It is imperative to understand what forces have been driving the company’s high margins. This will affect the sustainability of such margins and potential risks. For example, if margins have risen due to a temporary price increase in a volatile commodity, the higher margins will prove to be transitory and margins will reverse when prices decline.
Similarly, temporary boosts to margins from lower raw material costs are likely to unwind relatively quickly and it owes nothing to prudent management. However, a sustained effort by management to improve and source for more cost-effective/higher quality components is likely to offer longer term benefits.
If margins are boosted by solid volume growth, good pricing, new product developments and improved product quality, then it’s good. Not only margin expands but the company’s position and profile in the market will be boosted.
If margins are slim, is there any risk of going into a loss?
Low margins can mean significant risks as there is little chance for anything to go wrong. If margins are low due to things already going wrong, it may not take a lot to see profits swinging into losses. For example, a contractor with net profit margin of 1% may run into problems with a large contract and quickly see losses.
The risks are substantially higher if the business is highly volatile and subject to wide swings in volume and pricing.
If margins are a lot higher than that of competitors’, can the figures be believed?
Margins that are significantly greater than the competitors should be closely looked into. They may genuinely represent superior efforts from management – better products produced at a much lower cost. However, such margins can also reflect a less prudent approach to accounting – low depreciation charges, recognizing profit earlier than sensible. Henceforth, it is well worth being aware of any accounting issues that are flattering net profit margins.
Similarly, if a company is generating high margins for producing a basic commodity, scrutinize the basis for high margins.