Expressed as a percentage, net profit margins show how much of each dollar collected by a company as revenue translates into profit. For example, let’s say we own a lemonade stand. This week we brought in $10 in sales (that sucks, I know but its November in NJ. What do you expect). We don’t get to keep the $10 because we need to buy supplies to keep the business operating. I went to the store to buy some cups, markers and poster paper to make a few signs, and ingredients to make the lemonade and that cost me $8. There are $2 left over and that is our profit. To figure out our Net Profit Margin we divide our profit of $2 by the total revenue of $10 and we get a 20% Net Profit Margin (2/10 = 20%).
This is important because we want to be investing in a company that is able to keep as much of the money they bring in. The money they keep is profit and the money they don’t keep goes towards the expenses (or bills) the company has to pay to keep the business going.
We don’t want to use this metric to compare companies in different industries. For example, the grocery industry has a lot of overhead costs, therefore a great company in that industry will have a lower net profit margin compared to an average company in a services oriented business, like financial services, where overhead costs are significantly lower. However, this is an excellent tool to use to compare against companies within the same industry.
If we are researching a company and their net profit margins are higher than its competitors, it could be a sign of three things, all of which are very important. First, it’s a sign that the company could be the leader in their industry. I want winners (Mike Singletary voice). Second, it could be a sign that the management team is doing an effective job running the business. This shows that they are very efficient at bringing in money, keeping expenses low, and having money left over to grow the business or pay out dividends to its shareholders. Third, and most important, if they are consistently achieving higher net profit margins than the competition year after year, it could be a sign that there is something very special about the business, or as Buffett would say, it has a Moat. Any company could have a stellar year, and post great net profit margins in any given year, however the companies that are able to post higher margins year after year compared to their peers shows that they have some sort of competitive advantage.