The fifth and final part of this series deals with the profit margin, which is traditionally an undervalued concept in finance today. Profit margin is something that many shareholders are concerned about when going through the books of their company and they always urge directors to improve profit margins. But why do they do this?
Before answering this question, I will outline what a profit margin actually means just in case some people are not aware of the concept. Profit margins are obtained by dividing net income by net sales. This essentially shows what percentage of net sales becomes net income after taking into account expenses (including tax).
Therefore, a high profit margin means that the company is controlling its costs very well, which is what investors all look for. On the other hand, a low profit margin indicates a low margin of safety meaning that a decline in sales could quickly erase profits and result in a net loss.
The above explanation clearly demonstrates how advantageous it can be to be aware of the profit margins of a company. Nevertheless, Warren Buffett has his own way of using profit margins which have brought him so much success over the years.
The master’s technique is basically focused on looking at the history of profit margins of a company, whether it be 5, 10 or 20 years. A recommended time frame would be 5 years which should give you a good indication of profit margins have changed since. There are 3 patterns that should be observed, all of which are detailed in the following paragraphs.
A typical pattern observed is a stable profit margin over the time period chosen for the analysis. This can be both good and bad news for the investor. It is positive news for the investor if this is high because it means that any increases in expenses during that time have been absorbed and controlled well. It is negative news for the investor if this is low because it implies that the company has not been able to keep expenses under control over that period of time.
The second type of pattern is an increasing profit margin. This basically means that in your chosen period, the profit margin has steadily increased. This is great news for a budding investor, however, before choosing to invest in such a company, it’s recommended that you completely understand the other components of Buffett’s methodology before making a decision which are explained in my previous articles.
The third type of pattern is a decreasing profit margin. This basically means that in your chosen period, the profit margins have steadily decreased. This is certainly not good news for any investor because it means that management has not been able to control increasing costs over time. However, as I said before, any company should not be discarded without analysing the company using other components of Buffett’s methodology.
Overall, Buffett’s successfully methodology is based on 5 principles, which are all fully outlined in my articles for your own benefit. Any investor which is not aware of his strategies would be foolish not to study them. That said, you should not limit yourself to Buffett’s way of investing. There are many great and useful strategies out there, which I will be writing about in the next couple of days. Stay tuned!