posted by on Jul 21
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.
Now, that all may seem pretty simple to understand, which is true. It’s not difficult to see how profit margins can be useful in determining which companies to invest in. However, Warren Buffett uses profit margins in a different way to the typical investor and this is why his fortunes have not been necessarily typical.
The Buffett methodology revolves around historical profit margins. That is, profit margins recorded over a number of years in the past. A good strategy is to go back at least 5 years and see how profit margins have evolved since. In total there are 3 types of profit margin patterns that an investor can observe and the reason why they should each be understood is explained below.
The first type of pattern is a consistent profit margin. This basically means that in the last 5 years (or whatever number of years you choose to use) the profit margin has remained relatively stable. This is good news if the profit margin is high means that management has successfully been able to control any growth in expenses. However, it is bad news for any investor if this is low.
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.
All in all, Buffett’s methodology involves 5 components explained in this article and my 4 previous articles. The fact that the richest man in the world used this to achieve such success means that it must be learned and understood by all investors throughout the world. Nevertheless, this is not the only strategy to use. There are so many others with varying levels of success. Keep an eye out for future articles regarding new and important strategies any investor can use to become rich and successful.
