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.
Conclusion
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.
https://www.stockifyblog.com/single-post/profit-margin
https://www.stockifyblog.com/single-post/profit-margin
