To decide whether or not a particular company’s stock is worth including in a portfolio is a daunting task. An investor must analyze various company aspects before they invest their dollars. One key aspect to consider is the financial position of the company and more particularly the profit margin. A profit margin is the amount by which revenue from sales exceeds costs in a business and is usually expressed as a percentage. Here are 3 common types of profit margin points to calculate before investing in a company’s stock:
1. Gross Profit Margin
The gross profit margin is what the company has after the all the deductions of the cost of goods has been made. This is calculated by subtracting the cost of goods sold from the sales made and then dividing that number by the total sales. The formula for determining gross profit margin is to subtract the cost of goods sold from the sales, and then divide that number by total sales. Here is an example: if a company has made $10 million in sales, and the cost of goods is $3 million, the profit margin is: $10 million - $3 million = $7 million. $7 million / $10 million = 0.70, or 70%. The higher the gross profit margin, the more liquid a company is. The margin can help an investor to understand how well a company utilizes its raw materials and labor in production and how much the company is worth. A company that has a declining profit margin has less cash and subsequently is less liquid.
2. Operating Profit Margin
An operating profit margin is a measure of how well a company’s operations result in profits. It is obtained y dividing a company’s earnings before interest and taxes by its sales. The operating profit margin takes into account other costs like administration costs as well as the cost of goods sold. A higher operating profit margin shows that the company is efficiently managing costs and so it’s worth investing in. In our example above, a company might have $10 million in sales, but its earnings before taxes and interest are only $4 million. So the operating profit margin is obtained by dividing $4 million by $10 million to get 0.40 or 40%.
3. Net Profit Margin
The net profit margin is a measure of profitability and is calculated by dividing the net income by the company sales. Net income is the percentage of the amount of money that is earned after deductions of all the expenses from sale has been made. The net profit margin shows how managers and operations are perfoming. You can compare the results with that of other companies in the same industry so as to make the best choice of the company to invest in that particular industry. In our example above, the company might only have $4.2 million in net income. The net profit margin would thus be 42%.
A company’s profit margin is an ideal indication of how efficient the company is and well it utilizes its cash and other resources. It is a superb way to provide you an immense insight on whether you should include that particular company in your portfolio. An investor can use the profit margin to compare the success of large companies versus small ones. A low percentage means the firm's high costs reduce the profit for each dollar of income and thus it’s not a worth investing in its stock.