P&L: Profit margins 1 comments

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It is natural for us investors to focus on the topline or bottomline figures when looking at a company's financial statements, and it is true that the market often judges the company's performance by its revenue growth and more importantly, its profits. However, such a cursory scan has severe shortcomings: it does not reveal the quality of profits (we won't discuss that here) and furthermore, it is as important to examine one level deeper, into the relationship between the profit and the sales ie. the profit margin.

There are several reasons why profit margins are important, and a discussion of the various margins will help one to understand why. First is the gross margin, which is the ratio of the gross profit to the sales revenue. This very clearly depends on the cost of direct input (eg. raw materials, direct labour) which gives an idea of whether the company is able to pass its raw material cost rises to its customers ie. whether it has pricing power. For commodities trading firms (eg. HG Metal) this margin is very important, since its profit ultimately depends on the kind of margin it can get off its traded goods. For companies with high fixed assets eg. telcos, this might not be so meaningful since the fixed/sunk costs are not factored in.

This is where the operating margin, the ratio of operating profit to revenue, comes in. Essentially, it factors in both direct costs and indirect costs, such as overheads (fixed asset depreciation) and costs of operation such as distribution, logistics, administration, sales and marketing. For brand management companies this can be substantial since their contract-manufactured goods tend to be made relatively cheaply while marketing costs (eg. advertisements) would be sizeable. A good example is Osim. In such cases, watching the operating margin gives one a better overview of the company's progress in growing the profitability and strength of its brand.

Finally, the net margin is the ratio of net profit to sales revenue. It gives an overall view of how the bottomline relates to the topline, and reflects the company's ability to manage overall costs such that it lags topline growth (which of course, produces higher net profit margins --- a good thing). Also, I often use it as a parameter to sift out those with razor-thin net margins; these companies are always to find it an uphill battle to maintain profitability and one bad quarter could see them swinging into the red --- often leading to share price collapse.

There is another reason why margins are important. Typically the news of revenue and profits filter through to the investment community in advance of the official announcement, and it is not uncommon to see stock prices rising in anticipation of strong results which turn out precisely to be so. Hence these numbers, when they reach the investor, might no longer be so useful given that prices might already have factored them in. However, margin analysis represents an insight into whether further growth is likely, because it allows the investor to understand industry dynamics, pricing power and cost management efficiency. It therefore confers a medium-to-long term advantage for the investor who is able to use these tools knowledgeably.