A Quick Refresher on Margins

A Quick Refresher on Margins

Morning folks,

We’re seeing a healthy increase in new investors joining the MyWallSt community in recent weeks. Perhaps the sudden drop in equity prices spurred some long-time holdouts into action. In that case, I hope you acted fast as the NASDAQ is pretty much back to January levels. Or perhaps some extra personal time has given you the chance to finally get started. Whatever the reason, welcome. I hope you’re finding it enjoyable and enriching (or at the very least entertaining).

It’s coincided with an uptick in questions relating to some investing basics which I’m all too happy to discuss as part of the Daily Insights. Today, let’s talk about margins. Not trading “on margin” (which you should never do), but rather a businesses’ profitability margins and what they tell us about a potential investment.

Companies typically break down their profitability using three metrics — gross margin, operating margin, and net margin.

Gross margin is a measure of what a company makes by selling a product or service. The calculation is pretty straightforward — revenue less the cost of goods sold equals gross profit. Gross profit as a percentage of revenue is your gross margin.

Let’s say Tiffany & Co sell a diamond ring for $50,000. Before they can do that, they have to source the diamond, buy it, and eventually have a jeweler make the ring. All those costs, the costs of actually producing the product, come under the title of Costs of Goods Sold, often abbreviated as COGS.

Keep in mind that this doesn’t include wages for the person who sells you the ring, or the rent on the building you buy it in. This is simply the cost of the production of the goods.

In Tiffany’s case, the cost of that ring, on average, is $20,000. So they make $30,000 on the sale. That means they have a 60% gross margin — which is historically what Tiffany manages.

But what does 60% mean? Is it good or bad? It really only means something when compared with competitors. Other jewelers like Signet have gross margins of between 25-30%. This shows that Tiffany is able to sell its products for a much higher price than competitors — what we call pricing power. It’s a clear sign of a strong brand. Seeing those gross margins increase year-over-year would be another good sign. Either Tiffany has managed to increase prices or they’ve managed to reduce their cost of goods sold. Either is positive.

So we like to see companies with higher gross margins than competitors and we like to see them increase year-over-year.

Moving down the income statement, we come to the operating profit and operating margin. Operating profit is gross profit less all our operating expenses — these include sales and marketing, research and development, and general and administrative expenses. So here you have your advertising budget, your cost of developing new products, and other general fees like rent, legal fees, the CEO's salary, etc.

A well-run business should be using profits generated from sales to build and expand the company. As a company grows, it should generate more sales, and the cycle continues. If a company is spending $100 million on advertising but only generating $50 million in sales, we would say this company isn’t operating effectively. Eventually, they will go broke. That’s why we want to look out for companies that can increase their top line sales at a higher rate than their operating expenses. This is called operating leverage and should be expressed in increasing operating margins.

We can also break down operating expenses into their individual line items to see where exactly the money is being spent. In particular industries, like tech, you want to see a business spend money on research and development, as not doing so would leave them exposed to new competitors with advanced technology. You also want to see their sales and marketing expenses as a percentage of overall sales decreasing.

In short, a company that is able to increase its operating margin while increasing revenue, demonstrates that its management is good capital allocators. They’re spending money now to increase sales at a higher rate in the future.

Finally, we get to net profit and net margin. This the actual money that the company gets to keep after all the expenses have been paid. In between operating profit and net profit are what we call non-operating expenses. That includes interest paid on debt (or interest income if the company is cash-rich) and taxes. Net margin sounds like it should be the most important, yet it gets little mention in analysis. The difference between operating margin and net margin is largely a function of how good the finance department is. However, you can find businesses that have managed to bring down their effective tax rate much lower than competitors, which will, typically, give them an advantage.

I hope that’s answered some of the questions users might have had regarding what we’re talking about when we analyze businesses. You’ll see when companies report every quarter that the two big figures we focus on are revenue and earnings. Revenue is the money coming in the top of the funnel, and earnings are what come out the bottom — a function of how good the company is at keeping some money while putting some of it to work in order to grow the business.


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