Everyone knows that a stock’s price is often based upon a company’s earnings. While earnings are important, they are not the sole factor to look at in valuing a company. There are other factors that you have to take into account before investing. Today, we will cover number 7 in our list of 10 Things To Look For When Buying A Stock series.
Buffett loves companies that are able to consistently generate high profit margins. Profit margin is a simply a measure of a company’s profitability. Profit margin will tell you how much net income a company has for every dollar of sales. This is how much money a company is actually able to hold onto.
The formula is expressed as follows:
Profit Margin = Net Income/Revenue
The higher a company’s profit margin, the higher the margin of safety. A company with a high profit margin is doing a good job of controlling costs and is typically in better shape than a company that has lower margins.
It’s important to note that you should only compare profit margins of companies that participate in the same operating sectors.
For example it would be useless to compare the margins of Kroger to Apple. Grocery store chains have very slim profit margins and rely heavily upon operating efficiency. Technology companies have much higher profit margins due to greater pricing power.
Look for companies that have profit margins that are higher than industry peers. You want to invest in companies with profit margins that are either increasing or stable. Declining profit margins are a sign of potential trouble. An earnings increase does not mean much unless profit margins are rising as well.
Photo by Kevinzhengli
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