A company could be making many millions of dollars in sales, but if those sales don’t produce a profit, it does little good.
Thus, for companies and investors, the amount of profit made from each dollar of sales is crucial. That’s called the profit margin, and it is a financial measurement as important as sales and profits.
Obviously, the higher the margin, the better. If you can make 90 cents profit on every dollar of sales, you’re on your way to becoming a millionaire. If you make just a nickel per dollar, you’re having to sell massive amounts of inventory just to cover your costs.
But how much is a good profit margin?
It really depends on the company’s industry and its past performance.
Margins will vary from industry to industry. For example, a top-notch software publisher could easily extract, say, 60 cents out of each dollar of sales. That’s especially feasible after development costs are paid for, and all the publisher has to do is just make more disks -- or put the program on the Internet and save even more on distribution.
But retailers tend to have much smaller margins, because manufacturers often mark up merchandise to ensure their own healthy margins, and there are shipping, selling and operating costs for the store.
So investors can’t just look up a number and judge the margin to be good or bad. They need to study the company’s market and compare the margin against those of competitors. They also should compare current margins to what they were overthe past few years.
That’s not to say a small-margin company can’t become a great stock. For example, grocery chain Kroger (KR) was a winning stock in 2014 and early 2015 while generating annual pretax margins of around 2%. Supermarket margins are notoriously tight. Yet the company’s push into organic foods proved to be a success.
Sometimes, a company’s superior return on equity can offset weakness in profit margins. An ROE of at least 17% should be the minimum for a leading stock, and 25% or more is even better.
Quarterly after-tax profit margins are important too, and more timely since they are measured on a three-month basis.
In IBD, the annual pretax profit margin is shown on the table for the IBD 50 stocks published every Monday and Wednesday. It’s also on the Big Cap 20 table on Tuesdays.
The SMR Rating (Sales + Margins + Return on Equity) incorporates the company’s margins and is available in the stock tables and other places in IBD.
There’s a bit more detail at Investors.com, where the IBD Stock Checkup displays the annual pretax margin for each company you look up. The Checkup also provides a checklist with a color code for margins. Strong margins get a green dot, mediocre ones a yellow, and bad ones a red dot. This grading system does not take into account industry-specific factors.
The pretax profit margin also appears in stock quotes at Investors.com.
The table above lists companies with IBD Composite Ratings of at least 95 (a general definition of leading stocks) with pretax and after-tax profit margins of at least 20% in the most recently reported periods.
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