How to Use Margin Analysis as an Investment Tool

Apple, Celgene, Hansen Natural, and Immucor. What do they all have in common?

Believe it or not, each of these companies at one point delivered eye-popping share price gains of +2,000% or more -- turning even modest shareholders into millionaires several times over. Not coincidentally, all four firms have also been quite adept at converting sales into profits, boasting superior operating margins of 20% or higher.

As you might expect, these high-margin, fast-growing companies can trade at some fairly large multiples. But that shouldn't discourage a disciplined value investor.

First things first, let's review the basics of profit margins.

Essentially, margins are a gauge of profitability: after raw materials, worker salaries, and other expenses are deducted, they measure the percentage of sales that fall to the bottom line. In other words, out of every dollar of revenues coming in the door, it's how much the company gets to keep. By analyzing these figures, we can easily compare the profitability of firms of different sizes.

There are three types of margins that are most commonly seen:

Gross Margins = (Gross Profits/Revenues).  Every product or service has direct costs associated with it. For a pizzeria, those costs might include dough, cheese, sauce, toppings, etc. If you subtract the cost of goods sold (COGS) from sales, then you are left with gross profits. Gross margin is simply that figure expressed as a percentage of revenues.

Operating Margins = (Operating Income/Revenues). After COGS, there are other expenses needed to keep a business up and running, including salaries and advertising. Most of these overhead costs fall under the broad umbrella of "selling, general & administrative," or SG&A. To determine Operating Income, start with gross profits and then subtract SG&A expenses, as well as research and depreciation. Simply divide the result by revenues to calculate operating margin.

Net Profit Margins = (Net Income/Revenues). Net Income is the final bottom-line profit after all income taxes and one-time gains and charges are accounted for. Net margins measure total earnings as a percentage of revenues.

To understand the importance of these margins firsthand, just take a quick look at the two companies below.

On the surface, these two firms start out with identical annual revenues of $9.8 billion. However, that's where any similarities disappear. The first company banks just $790 million in earnings after operating expenses, while the second turns out a profit three times that size.

It goes without saying that earnings growth is a major driver of stock prices. And consider this, for Company "A" to increase its earnings by $1, it must find a way to boost its revenues by nearly $12. By contrast, Company "B" can accomplish the same goal with an increase of just $4.

Or from another perspective, for every new dollar of incremental revenue flowing into the two companies, the first will see less than a dime filter through to the bottom line, while the second will produce almost a quarter.

But looking to see how a company's margins stack up alongside industry norms is just the first step. There's a story behind any number, and the following three steps will spell it out loud and clear:

1.) View the Bigger Picture: Like all metrics, margins shouldn't be examined in a vacuum. By itself, a static number from last quarter or last year only tells part of the story -- look to see the overall trend. Are margins stable, increasing or decreasing?

2.) Dig Beneath the Numbers: Numbers can change overnight, so after looking to see whether a firm's margins are rising or falling, take some time to understand why. For example, if you're looking at a clothing retailer with a slight quarterly decline, it may have been nothing more than price markdowns and promotional sales to clear out seasonal merchandise. Or, it could be indicative of a coming price war or signs of a more serious problem.

3.) Scrutinize the Business Model: Part of being a successful investor involves not just assessing the current state of affairs, but making an educated forecast about how a company will respond under different operating conditions. And as part of that forecast, it's important to understand how future sales growth will impact Inflations -- and ultimately cash flows.

One of the key determinants is the proportion of fixed costs to variable costs. Determine how that specific company assigns cost as either fixed or variable.   As the name implies, fixed costs remain level regardless of business activity, while variable costs increase or decrease in proportion to sales -- for example, selling more pizzas requires purchasing more ingredients, that would be a variable cost.

For companies where expenses are mostly variable, then operating margins are likely to remain somewhat stable -- if a $10 pizza costs $5 to make, then gross margins are likely to hover around 50% regardless of whether the company sells 1,000 or 100,000.

By contrast, picture a firm with few variable inputs, but high fixed expenses of say, $10 million per year. Once those initial costs are recouped, then any additional revenues flow almost straight to the bottom line. If the firm takes in $11 million in sales, then it will have an operating margin of 9% and operating income of $1 million. But if sales climb to $15 million the following year, then suddenly margins improve to 33% and profits balloon to $5 million.

These types of scaleable companies are said to have a high degree of operating leverage -- every new dollar of revenues is more profitable than the dollar before. But this intensity of fixed costs can be a double-edged sword; just as rising revenues can lead to higher margins, sales shortfalls can cause them to contract rapidly.

If used correctly, margin analysis can be a great tool for an investor to use. How profitable a company is will affect both the company's and the investor's bottom line.  Just remember that it's generally not a good idea to compare the margins of two firms operating in different industries. The most instructive comparisons are those made among close competitors. That way, it's possible to evaluate the efficiency of a firm's managerial team with all the other background noise removed.

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