A profit margin is a metric that helps you understand how much revenue a company keeps after it has paid off all business expenses (such as employee salaries, costs of goods sold, interest on debt, and taxes). The profit margin can help you spot those companies that are apt at minimizing expenses while keeping sales up. Below, we’ll help you learn how to calculate profit margin, as well as how to use it in your stock valuations.
How can you calculate the profit margin?
While there are various ways of defining profit margins (we’ll look at the various types below), the most common calculation is net profit margin. This is a fairly straightforward calculation that involves taking a company’s net income (found on its financial statement) and dividing it by its revenue. When you multiply the resulting quotient by 100, you’ll get a percentage, which is your net profit margin.
Net profit margin = net income / revenue x 100
Note: when you’re making this calculation, the company’s revenue should always be higher than the company’s net income. The reason is that net income is what’s leftover when you subtract revenue by all of a business’s expenses, such as operating expenses, taxes, and the cost of goods.
For example, let’s say Company X has $20 billion in revenue. After we subtract out operating expenses, taxes, employee wages, and the cost to make Company X’s products, we’re left with $3 billion in net income. When we plug both numbers in our formula, we get a net profit of 15% ($3 billion /$20 billion x 100). That means, for every dollar that Company X generates in sales, it earns $0.15 in revenue.
Types of profit margin
When investors speak of profit margins, they’re almost always taking about “net” profit margins — that is, the money that’s left over when a company has factored out business expenses, employee salaries, and taxes. There are, however, several types of profit margins — each with its own analytical advantages. Let’s take a brief look at three other common profit margins.
Gross profit margin
The gross profit margin tells you how much profit a company makes after you subtract all costs related to production, such as the raw materials that make up the product, the costs to transport goods to stores, and the labour involved to produce and sell it. A formula for this would look like this:
Gross profit margin = (net sales – cost of goods sold) / net sales
Operating profit margin
The operating profit margin takes gross profit margin a step further; in addition to subtracting out the cost of producing goods, the operating profit formula also subtracts costs that are indirectly connected to the creation of products.
For instance, operating profit would include the salaries from a company’s HR, technology, and marketing departments; the rent and utilities on a company’s buildings and headquarters; and any costs associated with advertising or promotions. The formula for operation profit is this:
Operating profit = operating income / revenue x 100
Net profit margin
Finally, we have net profit margin. If operating profit margin took gross profit margin a step further (adding all costs of product, direct and indirect), net profit margin takes it to the very extreme: with net profit margin, you factor in every cost a business incurs, from taxes to interest on debt payments to, yes, the cost of goods produced. When you divide all costs by the company’s total sales for a given period, you’re left with a fairly accurate understanding of how profitable a company truly is.
Now that we’ve covered operating and gross profit margins, we can expand our formula from above. Here’s a more detailed look at the net profit margin formula:
Net profit margin = net income (revenue – cost of goods sold – operating expenses – interest – taxes – other expenses) / revenue x 100
How to use profit margin wisely
Like other valuation metrics, profit margin is most helpful when you use it to compare companies in the same sector or industry. Every market sector will have a different “norm” — some industries will see single-digit profit margins as normal, while others will see single digits as a sign of trouble, which makes cross comparisons pretty much useless. But if you use profit margin to compare companies in the same sector, you can get a pretty good understanding of which ones are more profitable than others.
As a word of warning: certain one-time events can easily skew profit margins. For instance, if a company sells certain assets, profit margins could look inflated, whereas one-time expenses can make a company look less profitable than it is. Because of this, you should definitely use profit margin with other valuation metrics so as to get a more accurate picture of a company’s financials.
Despite these limitations, the profit margin can help you understand how well a company can make sales go up and expenses go down. If one company has a higher profit margin than its competitors, that could indicate a solid investment.