When investigating companies to invest in, I look at several margins – gross, operating, pre-tax, and net profit margin. But I focus on operating margin. Operating margin is the difference between how much you make and how much you spend to operate the business. If the “making” is at least 15 percent higher than the “spending,” I’m interested.
But there’s something else I need to know…
Was the operating margin lower or higher last year? And the year before? And the year before that? I like to see margins on an upward trend. It could mean several things, like…
• Strong and/or rising pricing power
• A shortage of products (Think Harley-Davidson, which deliberately makes fewer bikes than they could sell.)
• Technological leadership
• A transition from lower-end to higher-end products
• Rising productivity
• The ability to effectively manage costs
It takes more homework to figure out what is driving higher margins, but all of the above possibilities are good. So with an operating margin on an upward trend, even without doing the homework, you already know the company is running its business from a position of strength.
Profit margins go to the core of what makes a business successful. If you want a reality check, consider retailers.
Many retailers sold more product than ever during the 2008 holiday season. But because they had to slash prices to get customers to buy, their margins were squeezed to the max. So while sales were up, profits were down. That’s what happens when margins go in the wrong direction.
If you want to do the research yourself, the numbers are provided online by Reuters Finance. Just look up a specific company and click on “Ratios.”