Analysts and investors can get a better grip on the financial health of a company by reading its quarterly and annual earnings statements. The profit margin (aka net income margin) is one of the most widely used financial profitability ratios. It tells us how much revenue, in percentage terms the company keeps in earnings.
The formula for calculating the net profit margin:
Net Profit Margin = (Net Profit ÷ Total Revenue) * 100
Other Types of Profit Margin
Gross profit margin and operating profit margin are two other primary profitability ratios. They’re easily calculated using the income statement subtotals and net profits.
Gross Income 750 —-> Gross Profit Margin 750 ÷ 1,225 = 61.2%
Operating Income 456 – --> Operating Profit Margin 456 ÷ 1,225 = 37.2%
Net Income 305—— Net Profit Margin 305 ÷ 1,225 = 24.9%
How Profit Margin Applies To The Markets
Basic fundamental analysis uses profit margins to compare a company to itself, competitors, and benchmark.
Here is how Apple (NASD: AAPL) compares to its industry and sector.
Profit margins can vary among sectors. Apple’s gross profit margin above shows 38.27%. That said, car maker BMW sees its profit margins in the low teens (2nd qtr 2018 was 11.4%). The average net profit margin for the S&P 500 stocks for Q1 2018 stood at 11.1%.
If you talk to an investor like Warren Buffett, he’ll tell you that he prefers to buy companies that have high net income margins. Financial analysts pull historical financial statements into financial models calculate margins, growth rates, and ratios. They do it because it helps them come up with forecasts and projections.
Sure, it’s important for long-term investors. After an earnings release or company update, traders are closely following what the company says about its net income margin. Now, if there are any surprises, you could see a whole lot of volatility in the stock.
When a company’s earnings change, the income statement will show where the changes occur.
For example, a big increase in the cost of goods sold will decrease gross profits and all other profits while a tax increase will only reduce net profits at the very bottom.
Think about it, if a company’s cost of goods sold and expenses are too high then it will struggle to turn a profit.
Net income margin is one of the most important financial ratios you’ll see on a financial statement. If you are an earnings trader, it is one you’ll want watch closely.
As with most financial numbers, they become useful when compared to something else. Think in relative terms.