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Fundamental Data: Margins
Sounds a lot like earnings, right? Well, margins are really just earnings expressed as a ratio — a percentage of sales. The advantage is that a percentage can be used to compare the profitability of different companies, while an absolute number cannot. An example should help. Going into 2006, discount retailer Costco Wholesale was on its way to earning fiscal-year net income of $1.1 billion on sales of about $58 billion. Rival Wal-Mart, meanwhile, was on pace to earn about $11 billion on sales of about $315 billion.
While comparing $1.1 billion with 10 times that amount for Wal-Mart would tell you that the latter was certainly earning more than Costco, it wouldn't shed any light on which company was more efficient. After all, Wal-Mart is simply the bigger company. But if you divide the earnings by the sales, you'll see that Wal-Mart was returning 3.4% on sales, while Costco was returning just 1.9%. The difference doesn't sound like much, but it's one of the reasons Wal-Mart trades at a higher price/earnings ratio than Costco.
Analysts look at various types of margins — gross, operating, pretax or net. Each uses an earnings number that's further down the income statement (see Price/Cash Flow for more on how the income statement works). What's the difference? As you move down the statement, different types of expenses are factored in. The various margin calculations let you refine what you're looking at.
- Gross margins show what a company earns after all the costs of producing what it sells are factored in. That leaves out a lot — marketing expenses, administrative costs, taxes and so on — but it tells you how profitable the basic business is.
- Operating margins figure in those selling and administrative costs, which for most companies are a large and important part of doing business. But they come before interest expenses on debt and the noncash cost of depreciation on equipment. The earnings number used in this ratio is sometimes called cash flow or earnings before interest, taxes, depreciation and amortization (Ebitda). It measures how much cash the business throws off, and some consider it a more reliable measure of profitability since it's harder to manipulate than net earnings.
- Pretax margins take into account all noncash depreciation on equipment and buildings, as well as the cost of financing debt. But they come before taxes, and they don't include one-time (so called "extraordinary") expenses like the cost of shutting a factory or writing off some other investment.
- Net margins measure the bottom line — profitability after all expenses. This is what shareholders collect (theoretically) and so closely watch.
Margins are particularly helpful, since they can be used both to compare profitability among many companies (as we demonstrated with Wal-Mart and Costco above) and to look for financial trouble at a single outfit. Viewing how a company's margins grow or shrink over time can tell you a lot about how its fortunes are changing.
From 1997 through 2005, for instance, Dell's net margins held steady around 4% to 5% even as PC prices were dropping fast. What does that tell you? Dell was manufacturing more efficiently, while at the same time driving down prices. Rival Compaq Computer went in the opposite direction — from roughly 8% to -5.3% — as the company ran into trouble digesting several acquisitions and began losing money. Things got so tough for Compaq that it finally sold out to Hewlett-Packard in September 2001 at a small fraction of its peak share price. Dell's stock, meanwhile, has tripled between 1997 and 2005.
| Source: Bloomberg, Reuters
Data as of December 30, 2005 |
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