Most investors want to see companies making money on a regular basis. Today we’ll look at the most important way this is done: profit margins.
Profit margin is the money left over from sales after a company pays its expenses. It’s usually expressed as a percentage of earnings to sales.
There are several subtleties traders should appreciate because not all margins are created equal. (But in general, bigger is almost always better.)
Let’s start with a company’s income statement, which has revenue or sales on top and works down to net income. Going down the income statement, you find three types of margin.
“Gross margin” is the first one and the biggest. This shows the impact of producing goods or services, like a restaurant paying for food and labor.
This is usually the most important margin because it shows the basic viability of a company’s business. Can it actually break even? Will it have money left over for other efforts, like expansion?
“Operating income” is next. It’s the gross margin minus back-office costs like marketing and research and development. This is separated out because it’s not directly linked to generating sales.
Profit margin, or net (income), margin is last. This factors in the cost of taxes and interest payments. It may also include unusual items like the gain or loss on divesting business lines.
Different kinds of companies spend more at different places on their income statements. In general you’ll notice that “intellectual property” firms like software makers or drug companies have big gross margins but smaller operating margins. That’s because their products are cheap to produce but expensive to develop and sell.
It’s just the opposite, however, for an industrial firm cranking out machinery or cabinets. They tend to spend much more on materials and labor than a software company or pharmaceutical maker.
Generally, these things don’t matter much to traders. All we really care about is recognizing when margins are driving price and being able to understand analyst notes and news reports.
Now that we know the three kinds of margins, let’s consider the two ways they fluctuate: Either prices or costs change.
It’s obvious that higher prices are good for margins, and vice versa. But there are subtleties.
A company may not raise prices in an obvious way. Consumer-product firms, for example, may introduce new products with higher margins. That’s why apparel stores push accessories like belts, or soft-drink companies push 20-ounce bottles of soda.
Customers might spend similar amounts of money or think they’re “getting more.” But in both cases they’re really just paying higher prices and helping margins. Analysts often call this “product mix.”
It also raises the important point that good corporate managers should only introduce new products with a positive impact on margins. That’s why successfully selling new goods or services is generally positive for earnings.
Then we have “operating leverage” — margins can widen as revenue increases. In this case, gross margin may remain the same. But operating margin grows because there’s more profit spread over the same administrative and marketing costs.
Those are examples of the top line, or revenue, driving margins. The other big story is when costs further down the income statement impact margins. These are fairly obvious because higher costs for material, fuel or labor hurt profit. Just the opposite is true when costs fall.
Finally, let’s take a step back and put margins in context for different kinds of companies.
Say you have a food company with a stable business. Small changes to their product mix or costs can have huge effects on their success and share prices. Because their markets are finite and known, investors want to see them make the most of the business they have.
But then you have tech stocks, where investors demand growth. Margins have a different meaning for these companies when they provide clues about the overall business. For example weak margin guidance for chip or software makers could indicate weak pricing. That, in turn, could mean orders are weak, which in turn raises questions about growth.
We saw this with Apple’s (AAPL) last earnings report with the iPhone maker raising prices to fatten margins. But no one cared because the overall business, expressed in unit volumes, got a lot worse. Likewise, investors were happy with Netflix (NFLX) or Spotify (SPOT) sacrificing margins to keep growing.
In conclusion, remember that margins can impact share prices in several ways. Traders need to heed their basic direction (getting better or worse?) and understand the various ways the market will interpret the news based on the industry. Hopefully this post will help you make some of those judgments.