Why profit margins are really useful
In this video, Ed Bowsher explains how to calculate a company’s profit margin, why it is the best way to evaluate profitability, and how you can use it when analysing a company.
If you want to find out how profitable a company is, you might just look at how much profit the company makes. But that doesn't really tell the whole story. The profit margin figure is much more useful because it enables you to compare the relative profitability of two or more companies.
In this video, I explain how to calculate the profit margin, why it is the best way to evaluate profitability, and how you can use it when analysing a company.
Firstly, how do profit margins actually work? Well, there are different profit margins going with the different measures of profit. We've talked about these different measures of profit before. One of them is gross profit. Let's say we're making a table. Let's say we sell the table for £200, and the core costs of making that table, the woods and the labour for the people who made that table, are £50.
The cost is £50. The revenue is £200. We've got a gross profit of £150. Let's turn that into a gross profit margin. We've got that £150 gross profit. We've got the £200 revenue on the table. That table is a 75% gross profit, or the company is making a 75% profit margin.
Then, going down the list of profits, we've got the operating profit that's when we add in the costs for things like the support staff, the electricity for the factory, the heating, and all the rest of it. Obviously, your operating profit is going to be lower than your gross profit. The gross profit was £150. Our operating profit is £100. It's £100 over £200 and we've got a 50% operating margin.
That's useful, because it helps us compare how different companies are doing. I'm going to look at two companies, one called Company A and one called Company B. We've done that a few times before in these videos, and we're not going to stop.
Here we have Company A. It's making a £100m operating profit last year. Company B made a £60m operating profit last year. If we forget all these figures over here, just focusing on those two numbers, £100m and £60m, it looks like Company A is the more profitable company because it's generating a bigger profit.
It is, and in a way that makes it the more impressive company, but let's then look at the revenue. Company A has a £1bn of revenue. Company B has a much lower revenue, £300m. When we divide the profit over the revenue we get a 10% operating profit margin for Company A, but Company B, where we're dividing £60m over £300m, that gives us a 20% operating profit margin for Company B.
We can see that when you look at the revenue, Company B is extracting more profit out of that revenue. It is truly a more profitable company with a higher profit margin.
Another word for operating margin is the return on sales, if you've got £300m of sales, how much profit can the company and the management extract from that revenue? It's similar to when we talked about return on assets, when we said we've got a factory that cost £100m, how much profit can the company generate from those assets? That's your return on assets, your return on capital.
Now, we're looking at how much profit can the company extract from its sales, the return on sales, or the operating profit margin. We can see that, all other things being equal, Company B looks better than A because it's got a higher margin.
Comparing profit margins I think is particularly useful when you're comparing two or more companies within a particular stock market sector. Different sectors tend to have very different profit margins. We could compare, say, Next and Marks and Spencer broadly similar businesses selling clothing.
Right now, Marks and Spencer last year had sales of about £10bn. Next had sales of about £3.75bn. Yet, they both generated operating profit roughly the same amount around £700m. Marks and Spencer, remember, has £10bn of sales, Next has £3.75bn of sales, yet Next, with much lower sales, managed to generate just as much profit.
Next's operating profit margin is 19%. Marks and Spencer's profit margin is just below 7%.
When you look at those two figures in isolation, all other things being equal, Next looks like much the more attractive company. Indeed, I own shares in Next and I don't own shares in Marks and Spencer. It's much more profitable. The profit margin shows you that really quickly and easily, and you can make that distinction between the two companies.
I think also when you're looking at profit margins, you want to find a company where historically over a long period, margins have either been steady or rising. If you've got a company where the profit margins are falling, that suggests either the company can't keep costs under control or it's not able to persuade its customers to accept higher prices. Using the jargon, it's got poor pricing power. Either scenario is bad news, so a falling profit margin is a real warning sign that there may be problems with this company.
As I said a minute ago, different sectors generally have very different profit margins. One sector that has traditionally low profit margins is supermarkets. Tesco currently has an operating margin of about 4.5%. If you just look at that figure in isolation you might think that's very low, that suggests you shouldn't invest in Tesco. As it happens, I'm not keen on Tesco. I explained that in a video the other day. https://moneyweek.com/videos/should-you-invest-in-tesco/
But, the 4.5% margin of itself doesn't put me off. Supermarkets are a business with a high volume of sales, and they work by having that high volume of sales and then extracting a relatively low profit. Because they're selling so much, the business can work. What's more, supermarkets get money in from their customers very quickly at the cash register, and then they're very slow at handing that money onto their suppliers. That helps them be a bit more profitable than the margin may suggest. I wouldn't invest in Tesco, but the 4.5% margin isn't a screaming signal that everything is wrong with this company.
Hargreaves Lansdown, the stockbroker, is right at the other end of the margin table, if you like. It's got a 65% operating margin, which is fantastic. In many ways that says go and buy Hargreaves Lansdown right now. The one thing that worries me, though, is I think that such a high margin suggests that Hargreaves is charging its customers too much which it does so I think it's vulnerable to competition on price. I think that margin may fall, and so maybe Hargreaves isn't such a good investment after all.
That's a really quick overview on margins. I hope I've explained the idea that it really can help you compare two or more companies in the same line of business.
I'll be back with another video soon. Until then, good luck with your investments.