What are Margins?
Margins tell you how much money a company retains from its sales after deducting costs. They are therefore a measure of profitability and expressed as a percentage of sales.
Quality companies tend to possess characteristics that make them extremely profitable. As such, margins are an extremely useful metric when screening for them. I will outline some of the economics behind this below.
If we look at the following formula, we can see the components that drive margins:
Where P is the average sales price per good. Q is the quantity of goods sold. And C is the average (unit) cost to make each good.
After rearranging the formula we arrive at the final term. It shows that a company’s profit margin equals the difference between the average price and average cost, divided by the average price.
For example, if P = £10 and C = £5, then profit margin = (10-5) ÷ 10 = 50%. That is, the company gets to keep 50% of its sales as profits after costs.
How Can a Company Increase Margins?
1) Raise Prices
Looking at the last term in the formula above, we see that a company can increase its margins by raising prices above cost inflation. If it can do this without any significant decline in sales volume, then overall profits will increase. Since raising prices requires no capital expenditures, this also enhances returns on capital.
When a company can raise prices without significantly hurting sales volume, we call its product(s) demand inelastic. A good is inelastic if demand for that good is insensitive to price increases. This is the essence behind pricing power.
Pricing power means that a company can protect margins without losing too much market share to lower-priced competitors. This is only possible with a unique moat/competitive advantage. If its products don’t offer something differentiated, then competitors can undercut on pricing and steal market share. Eventually, the company losing market share will capitulate and lower prices themselves, forcing margins to mean-revert to market levels.
2) Optimise Product Mix
The other way a company can increase margins is to shift its sales mix towards higher margin products. Since margins are based on the average prices and costs of the various products a company sells, this means that selling a greater share of higher margin products vs. lower margin products will increase overall margins.
Unlike raising prices directly, this does involve some costs (working capital investment). Therefore, the benefits to margins and returns on capital are more muted with this strategy. Quality stocks tend to manage working capital efficiently and are always optimising their product mix.
3) Reduce Average Costs
The final way that a business can increase margins is by reducing average costs. Putting aside any naturally occurring price deflation (e.g., from raw materials), the most sustainable way to reduce average costs is by improving efficiency in the production process. The second way is through economies of scale.
Economies of scale occur when a company’s average costs decline as its output (sales volume) increases. There are many reasons why this can happen. For example, larger companies tend to buy in bulk from suppliers and for advertising space. This means it can negotiate better terms (lower unit costs). Large companies also have the resources to integrate new technologies into their production process and improve their efficiency.
A common feature of businesses with strong economies of scale are asset-light business models. Being asset-light means that acquiring new sales is relatively cheap.
Netflix is an example of this. After expending the initial costs to develop the platform and acquire server space, its content is ready to distribute worldwide. These initial costs are fixed, and so as new customers subscribe, there are more sales to spread these fixed costs over. The mathematics of this reduces average costs.
This is obviously an oversimplification, but the point is that its cost structure has low asset-intensity. Compare this with a traditional retailer. They need to constantly build physical stores and distribution networks to acquire new customers – a costly process.
Using Profit Margins to Screen for Quality Stocks
If you want confirmation that margins are a great barometer of quality, then look no further than Fundsmith’s portfolio analytics. Terry Smith (CIO) is one of the most well-known and successful quality investors of all time. So one would be remiss to ignore that margins feature twice in his list of favourite fundamental ratios.
In this article, I show how to incorporate return on capital metrics into stock screener criteria for quality stocks. In it, I show that profit margin is a key driver of returns. Moreover, in this article on how to use a stock screener for quality investing, I show the relationship between returns and a company’s growth potential. Therefore, margins are not only important for a company’s profitability, but also its growth.
Whilst it is preferable for a stock to have the highest margins possible, it is important to remember that different industries have naturally different cost structures – and therefore different margin profiles. For this reason, we shouldn’t necessarily overlook a stock in a typically low-margin industry compared to a stock in a typically high-margin industry.
A business that has consistently higher margins than its industry average will still possess pricing power, scale, efficiency, and a durable competitive advantage vs. its peers – all the things we look for when deciding whether a business has a strong economic moat.
Profit Margin Screening Approach
When using margins as our metric to screen for quality companies, there are generally three approaches you can take:
- Screen for companies with the highest absolute margins in a stock universe
- Screen for companies with higher margins relative to their industry peers
- Or, screen for companies whose margins have been growing in recent years
Remember, margins can be volatile, so I prefer to look at how margins have trended over the last few years and take an average. If a company has shown margin stability over a period of time, this is usually a sign that they have a durable competitive advantage.
Whilst the first two approaches concern profitability levels (absolute or relative), the third approach concerns profitability growth – and hence a company that may be establishing itself as a quality stock.
GuruFocus Profit Margin Screen
The GuruFocus screener is extremely versatile when it comes to margins. It essentially allows us to implement all of the 3 approaches mentioned above. The screenshot below illustrates this.
This particular screen is looking for stocks with gross profit margin growth of at least 5% over the last 5 years (approach 3). A 5-year average (median) operating margin of at least 20% (approach 1). And a net profit margin in the 10th percentile (top 10%) relative to its industry peers (approach 2).
This returned 43 stocks in the US stock market, which includes all the main exchanges like Nasdaq and the New York Stock Exchange.
In addition to the three main profit margin definitions detailed below, the GuruFocus screener also allows you to screen on pre-tax profit margin and free cash flow margin.
What are the Different Types of Margins?
A business has numerous costs, so depending on which costs you deduct from sales you will get a different margin definition. The three types of margins that investors analyse are gross margins, operating margins, and net (profit) margins.
Gross Margin
Gross margins are calculated by dividing the gross profit of a business by its sales, where gross profit is the profit made after subtracting the cost of goods sold.
Where COGS = cost of goods sold
The cost of goods sold include all the costs involved with producing goods, including raw materials, manufacturing costs, and labour costs directly associated with the production process. It doesn’t include payroll costs for employees associated with other parts of the business, such as sales, marketing, finance, or other areas.
Below is a snippet from Apple’s income statement. It shows the net sales and COGS for the quarters ending December 2020 and 2021. Net sales is total revenue (gross sales) minus returns, allowances and discounts.
These are further separated into hardware products and digital services to give investors more information.
For the quarter ending December 2021, you can see that net sales were $123,945 and COGS were $69,702. This gives a gross profit of $123,945 – $69,702 = $54,243.
Therefore, the gross margin in percentage terms equals: $54,243/$123,945 = 43.8%.
How to Interpret Gross Margins
Comparing the gross margins of industry peers is one of the best ways to detect companies with superior pricing power and brand equity.
From a cost of goods perspective, companies in the same industry will have similar direct costs. For example, soda companies must pay for water, carbonation, flavour, sugar, and storage. If factors like flavour and brand did not matter, consumers would simply buy the cheapest on offer.
While some do, many are willing to pay a premium for their favourite brand. The price difference appears in the branded soda maker’s higher gross margin. In effect, the company’s marketing and other brand investments are attributed a value by the consumer.
In this light, gross margin is the purest expression of customer valuation of a product, clearly implying the premium buyers assign to a seller for having fashioned raw materials into a finished item and branding it. Therefore, sustaining high gross margins relative to industry peers indicates a durable competitive advantage and associated pricing power.
High gross margins also confer other advantages: they can expand the scope for operating leverage, provide a buffer against rising raw material prices and provide flexibility to drive growth through R&D or advertising and promotion.
Watch this short video below to hear Terry Smith’s insights on gross margins. As well as confirming the above, he also states how it is one of the most underrated metrics for assessing business quality.
Operating Margin
Operating margin is calculated by dividing the operating profit of a business by its sales, where operating profit is the profit made after subtracting COGS and operating expenses (OPEX). EBIT, which is shorthand for earnings before interest & taxes, is another term for operating profit.
Where OPEX = operating expenses, and EBIT = earnings before interest & taxes, or operating profit.
OPEX include the regular selling, general, and administrative costs of running a business, such as wages, advertising, rent, supplies, logistics, and utility costs. It also includes research and development (R&D) costs.
Carrying on from the Apple example earlier, you can see that operating expenses are the sum of R&D expenses and SG&A expenses. In Apple’s case, this equals: $6306 + $6449 = $12,755 for the final calendar quarter of 2021.
Operating income (EBIT) is then calculated by subtracting OPEX from gross profits: $54,243 – $12,755 = $41,488.
Therefore, operating margin is: $41,488/$123,945 = 33.5%
Non-operating items such as investment income and interest and tax expenses are not considered when calculating operating margins. Therefore, operating margins tell investors how profitable the core operations of a business are.
If you want to know how efficiently a company is managing core business costs and turning their primary income sources into profits, then operating margins are the metric to analyse.
Any income and costs falling outside of core operating activities, such as investing and financing activities, are captured by net (profit) margins.
Net (Profit) Margin
The final margin definition is net profit margin. Net profit margin divides the net income of a business by its sales.
Net income is the profit a business makes after subtracting all operating and non-operating costs. It is therefore the most comprehensive measure of a company’s profitability and tells investors the amount of profit available to reinvest back into the business and/or distribute to shareholders.
The non-operating items included in the net margin calculation are things like interest costs, taxes, foreign currency gains, realised investment income, and other non-operating income.
If a company follows GAAP accounting principles, you might also see other items such as restructuring charges, unrealised investment income, and one-off gains or losses from asset disposals included too.
For example, below is from the income statement of Thermo Fisher Scientific, which provides medical devices to the health services industry.
As you can see, there are certain items included in GAAP earnings, but not adjusted (non-GAAP) earnings.
For Apple, we can see that non-operating income/expenses are consolidated into one-line item as a net figure. Subtracting this from operating income gives us pre-tax profit (EBT) of $41,241.
Finally, after subtracting taxes from this figure, we arrive at net income: $41,241 – $6611 = $34,630. And net profit margin is: $34,630/123,945 = 27.9%.
Summary
- Profit margins reveal the percentage of sales kept as profits after costs are deducted.
- Pricing power, scale, and efficiency are key to achieving high margins.
- Since quality stocks possess these qualities, margins are one of the best metrics to screen for them.
- We can find these stocks by screening for those with: higher margins than their industry peers, margins that have been growing in recent years, or margins that are simply superior to all others.
- The most well-known margin metrics are gross, operating, and net margins.