Monday, October 5, 2009

Margins Margins Margins!

We often talk about profit margins on this site. Analyzing the profit margins of a company can help you determine its profitability relative to its competitors. For example, if two competitors have equal net incomes but one has twice the profit margin of the other, then over time we may see the more efficient company steal market share and grow at a faster rate. (This can happen for several reasons, one being that it can simply lower its prices until its competitors are no longer profitable, thus dominating the market.)

One type of profit margin is a company's gross profit margin, which is its gross profit divided by its revenue. Gross profit gives a pretty good indication of a company's pricing power versus its product costs. In a previous post, we saw that Coke has a gross profit margin of 64%, indicating
people are willing to pay quite a bit more for Coke's products than it costs Coke to produce them.

While Coke has been able to sustain a strong margin for a long period of time, for most companies, attractive margins don't last long. This is because competitors are attracted to industries where profitability is high. To illustrate this, consider the net profit margins of the industries depicted below as they were in 2005:

Notice the high profitability of financial and energy companies. This high profitability in the finance industry is likely one reason that all sorts of new financial products and structures came into being: profits were high, and therefore the industry grew by pushing product proliferation to new heights. In the energy sector, the strong profits depicted above helped spur new oil exploration and new investment in alternative energies. In the past, this has led to increased oil supplies and reductions in the cost of energy, though these changes have taken time. While it remains to be seen if this process will occur once more in the next few years, it remains a distinct possibility.

When analyzing a company, be sure not only to consider its net income, but also the profit margins that contribute to that income. Compare the margins to competitors, and consider whether the company has a "moat" that can protect its margins from the competition. While margins are important, note that they are not the end-all be-all when it comes to profitability, as they don't consider asset utilization. A company able to generate revenue and income on fewer assets is preferable to one that constantly needs capital infusions to grow.

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