Not All Profits Are Created Equal, See Operating Margins

Evan R. Guido Financial Advisor

It's not how much money you make, it's how much you keep. Investors in public companies learn early in the game that growth companies can double and sometimes triple their revenues during their early growth stages, but that does not mean they necessarily earn a profit.

Internet companies are great examples of companies with high revenue growth but little or no profits. How much are these companies worth? Well, their volatile stock prices on Wall Street indicate that investors aren't quite sure how to answer that question.

Once a company does generate profits, it's much easier for investors to determine its value. The percentage of a company's revenues that are left after all its costs are taken out is known as profit margin.

Some very profitable companies generate $50 in profits for every $100 they generate in sales. That means they have a 50% profit margin. Some companies have $3 in profits for every $100 they have in sales. That's a 3% profit margin. Which company is a better investment?

Comparing profit margins as a way to analyze companies and make investments decisions is an essential component of successful investing. But, you need to know some ground rules.

1. Make sure you are comparing apples to apples. In other words, don't compare an operating margin (sometimes called a pretax margin) with a net profit margin (after taxes)
2. More importantly, you shouldn't compare companies in different industries. Every industry has its own set of profitability benchmarks. The real key is to compare companies in the same niche.

With that in mind, let's turn our attention to certain industries and see what's what.

Let's start with an area that touches most of us daily - the supermarket business.

Food retailing is a notoriously competitive business and as a result, profit margins can be slim. As a hypothetical example, two supermarket chains - A and B - compete intensely for business. Supermarket A is traded on the New York Stock Exchange. Supermarket B is not publicly traded, but it files reports with the SEC because of the number of employees who own stock in the company.

Suppose the operating margins of the two companies over a three-year period of time as filed with the SEC were as follows:

If Supermarket B were publicly traded, it is quite possible that its shares would be in higher demand than its competitor.

Why? In short, the tighter the margins, the less likely investors are to swarm around a stock, especially if the company is one of many and ranks in the middle of the pack.

Also, if a company's profits margins are declining, you may see its stock drift lower. So, bottom line: Watch the bottom line.