profit-margin

Why Net Profit Margin is so Important

Selecting a company for a portfolio based only on absolute metrics such as revenue or net profit is difficult. They do not reflect the structure of the business and its costs. Therefore, to compare issuers, they often use multipliers that take into account all expense items. One of them is Net Profit Margin.

The margin is the difference between the price of a product and its cost. It is an absolute indicator, usually expressed in monetary units. There are 3 multiples, calculated in percentages, used in business efficiency evaluation:

  • Net Profit Margin – Net profit margin. It reflects the ratio of net profit to the company’s total revenue.
  • Gross Profit Margin – Gross Profit Margin. Calculated for gross profit (the difference between the company’s total revenue and the cost of its products).
  • EBITDA margin. Defined as the ratio of EBITDA to revenue.

An example of the presentation of the information at smart-lab.ru – below. Here the Net Profit Margin multiplier is published under the name “Net Profit Margin”.

The main advantage of Net Profit Margin over Gross Profit Margin is that this multiplier allows you to take into account all costs of the company, not only those resources that go directly to production. The indicator allows you to take into account the cost of covering debts and other payments, which the business will not be able to drastically reduce, especially in times of crisis.

The margin of a business is a good indicator of its sustainability. The higher the figure, the less likely it is that a company will go bankrupt because of a drop in the price of its products, a drop in customer buying or an increase in production costs. All other things being equal, a business with a good margin is preferable for long-term investment. It will be less affected by negative external factors.

The dynamics of net profit margin are also used to evaluate the effectiveness of management. Ideally, this indicator should steadily grow due to both revenue growth and cost optimization.

Comparing issuers by profit margin has several advantages.

 

  • The simplicity of calculating the ratio. Even if you want to analyze a company for which online services do not publish this figure, you can easily calculate it yourself.
  • Since all costs are excluded from this multiplier, you will use it to get an accurate idea of the efficiency of the issuer.
  • Through this indicator, you can compare businesses of different caliber, different levels of leverage, etc. The absolute value of net income will not allow you to take into account the scale of production, debt service costs, and other important indicators.

But like any multiplier, Net Profit Margin has its drawbacks, because of which it cannot be considered universal and should only be used in combination with other multipliers. Disadvantages of the multiplier:

  • The company’s net income is used to calculate it, and this figure can be manipulated by accounting methods.
  • There is no universally accepted norm of what value is considered normal or good, and what value is unacceptable.

The second disadvantage of Net Profit Margin makes this multiplier suitable for comparing issuers only within a single industry. In addition, you need to consider what phase of development the business is in. If a company has started investing large sums in new investment projects and increased CAPEX, its net profit and margin will become lower while maintaining the same revenue volumes.

Also, an increase in Net Profit Margin does not always serve as a sign of increasing business efficiency. For example, in the case of oil producers or metallurgical companies, it can occur due to price increases on global markets and can be temporary in nature. So use this multiplier in conjunction with others.

Conclusions

Profit margin is an important indicator of business sustainability. But even if you see that one issuer has it higher than another, it does not indicate total superiority of one company over another, even if they belong to the same industry. Also, if a company’s net income and margins are lower than a competitor because it’s actively reducing its debt load or upgrading production, that’s more of a positive thing for a long-term investor.

Tell us in the comments what measures of business profitability you look for when selecting stocks.

 

 

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