Today we are going to talk a little bit about profit margin and how does it affect the profitability of a business. In general, profit margin tells us how much money can the company earn for every dollar of sales. While doing analysis for a company, we will come across 3 types of profit margin: gross profit margin, operating profit margin, and net profit margin. We will try our best to explain these.
What is profit margin? To put it in a simple term, profit margin means how much profit can we earn from every dollar of revenue/sales. For example, when we sell a shirt for $ 100 revenue, after deducting various costs and tax, it is left with $10, and that is the profit that we actually earned. By selling shirts, it can give us 10% profit margin.
Gross profit margin (GPM) is calculated by dividing gross profit over revenue, where gross profit can be simply obtained by subtracting Cost of Goods Sold (COGS) from the revenue. COGS is the cost that we spent to build up the inventory before selling to the customers, or deliver a service to the clients. It is the direct cost that includes everything to build up the inventories of the business. This is the first profit margin that we usually calculate. However, GPM can be rather misleading than telling the real picture of the earning efficiency of the business, because of COGS can be significantly varied across different industries. For example, service providing business might have little to none COGS, which gives very high GPM. Hence, it leads us to look at the next profit margin.
Operating profit margin (OPM), as its name suggests, is calculated by dividing operating profit over revenue. Operating profit is the profit that left after deducting all operating costs including Sales, Goods, & Administration (SG&A). This gives a better profit margin of the business than GPM. However, it does not include financial costs, depreciation, amortization, and taxes which makes it also known as EBITDA. Basically, using EBITDA to calculate the business profit margin is one of the popular ways among analysts. However, the exclusion of financial costs and income tax can be misleading, because financial cost might have significant impact to high debt companies, while income tax can be different across industries due to some special tax incentives or deduction. Hence, here comes to the last type of profit margin.
Net profit margin (NPM), is computed by dividing net profit over revenue. Net profit is the final earnings after all kind of operating costs and incomes, financial cost/ incomes, depreciation, amortization and income tax. It is one of the commonly focus metrics. However, it does has its weakness, where non-recurring items are included as part of the net profit, which sometimes blurs the net profit. Nevertheless, NPM is important for a company as nothing matters if the operating earning of company does not translate into the final earnings.
So, how do these profit margins impact business earning power? Let us do some comparison between various parameters and net profit of the companies.
Scenario 1 – High profit margin VS low profile margin
Let’s assume there are two companies operating on two different business. Company A has a NPM of 10%, while Company B’s business is running at thinner NPM of 5%. Say the starting revenue and revenue growth for both companies are the same at 10% CAGR over 5 years. We will obtain the following result.
We can see that despite of having the same revenue CAGR, and same revenue at $805.2 mil at Year 5. Company A has posted a net earning of 80.5 mil, while Company B has 40.2 mil net earning, which is 50% lower than company A. The reason? Company B’s business has only half of Company A’s NPM, which led to such a significant difference in their earnings.
Scenario 2 – Similar CAGR but one improves NPM by 0.1% annually
Now, let’s assume Company B has a same industry same business model competitor called Company C. Due to the general industry sentiment that they are operating at, Company C has similar revenue CAGR of 10% per year. However, the management also invested some CAPEX to improve their productivity and operation efficiency, which led to a slight improvement in their net profit margin. We assume that their NPM improved by 0.1% per year for that past 5 years. Let us see how’s their performance.
From the result above, Company C’s management has put in efforts and money to improve their efficiency, and was only able to improve their NPM by 0.1%. However, this slight improvement in NPM has given them a CAGR of 12.1%, where their net profit at Year 5 is 44.3 mil, which is about 9.1% higher than what Company B is earning. This shows us that business growth associated with improvement in net profit margin, can have significant impact in net profit margin.
Scenario 3 – Similar CAGR but one has NPM dropped by 0.1% annually
This time, here comes Company D to compete with Company B and C in the same industry. Despite of the having same revenue growth as the other two, Company D has higher operating costs than the other two. Unfortunately, the management did not put much effort in rectifying the cause of higher operating costs over the years. As a result, their NPM has dropped by 0.1% per year.
As a result, the company has posted a net earning of 36.2 mil, with 7.7% CAGR for the past 5 years. In this case, the 0.1% NPM drop pear year over the past 5 years, have given them 10% lower in net profit against Company B.
Putting all these results together, we obtained the graph below, where the net profit of Company C has slowly outperformed the other two companies with increasing significance despite of having similar revenue growth.
Sharing of Experience
One of us in Stockify shared his investing experience with ECS (5162) and what he has learnt from it. ECS was a distributor of various ICT products and provision of ICT services. It has been in net cash and debt free position over the years despite of tough business environment. The management has been generous and rewarding its shareholders well with good dividend payout. In general, it is a good company which has limited downside.
Taken from ECS Annual Report 2010
The main contribution of ECS’s revenue comes from distribution of ICT products. However, due to its business nature, ECS business has a razor thin net profit margin. This means it is a challenging business, and could be vulnerable and sensitive to any unfavourable change in the business environment. Unfortunately, the significant weakening of RM against USD for the recent years has significantly increased the company’s cost and made its profit margin thinner. This has shown an impact on their profitability in recent years.
Taken from Malaysiastock.biz
Looking beyond the fundamental numbers, we believe that it is also important to consider business model as what we always emphasized in the our previous company analysis posts. An easy to operate company can give us some “Qualitative Margin of Safety”, which could impact the investment risk. With all these considerations, he came out with his conclusion that ECS is a company with solid fundamental that is managed by good management in a challenging business environment. His main concern is the challenge that company has faced and the reflection of decreasing profit margin over the years. Hence, he decided to give up on the solid fundamental figures of ECS due to its challenging business model. Nevertheless, readers should take his personal view as a pinch of salt as it does not indicate any buy/sell towards the company, but always be reminded to consider the profit margin of a business and the reasons behind it while analysing a company.
Today, we talk about various profit margins as well as their weaknesses. We also did some comparison with some superficial examples, to show that the significant impacts of net profit margin on the company’s profitability, where slight change in net profit margin could significantly affect the net earnings in a longer term, hence, shows the importance of management’s effort on improving the productivity and efficiency of their operation. And lastly, we also shared an opinion on ECS to show that how profit margin could be used to evaluate a business model. We hope our sharing today is useful to all readers and as always, take care.