what they are
They’re the portion of revenue, usually expressed as a percentage, that remains after costs of s certain type have been deducted. The most common types of margins used in financial analysis are:
gross margin, meaning what’s left after deducting the direct costs of providing the goods or services
operating margin, meaning what’s left after deducting both direct costs and sales, general and administrative (SG&A) expenses. Sometimes depreciation is also considered an operating cost, sometimes not, depending on the convention being used.
pre-tax margin, meaning what remains after deducting all costs other than taxes
after-tax margin, meaning income remaining after all costs, including taxes–but not including preferred stock dividends, if any.
do high margins mean a good company?
Many growth investors, especially tech-oriented ones, look for high margins as proof that a company owns patents, copyrights or other intellectual property that defend it against competition. MSFT or INTC might be good examples.
Low margins, these investors believe, are indicators that a firm is in a commodity business. This means that competition forces revenues down to levels very close to the cost of production. Profits accrue either to no one or mostly to the low-cost operator. Entrants in such industries are continually in a dog-eat-dog fight to push their costs below those of rivals. No one stays in the low-cost seat for long.
Value investors, with their customary dour dispositions, take the opposite view. They think high margins are like waving a red flag in front of a bull. Firms that demonstrate them are disasters waiting to happen. Sooner than you’d expect, they opine, competition will emerge, margins will compress and the stock will implode.
I line up more or less with the value guys on this one, even though I don’t agree with them 100%. There are some perennial high-margin firms, where competition hasn’t proved an issue over decades. Nevertheless, it’s hard to argue that either MSFT or INTC have been anything but disasters as stocks so far in this century, despite their near-monopoly positions.
taking margins at face value is foolish, in my view
–If you assume that margins at any level are fixed, you’ll miss perhaps the crucial element in forecasting future earnings–operating leverage. This is the idea that some costs are fixed and don’t rise in line with unit volume. As a result, the expense involved in selling an extra unit may be much less than that of selling the average unit.
–Rising margins almost always do invite competition. Companies like MSFT are the exception, not the rule, in my view. In most industries, the best companies will reinvest much “extra” margin in lowering their costs, as a way of discouraging new entrants.
–High margins usually aren’t “free.” Jewelry or furniture companies, for example, have very high margins. But they have to maintain very high inventories, which they turn only once or twice a year. That’s risky. The high margins in these cases don’t signal “free lunch”; they signal risk.
–I think the distribution company model–low margin, high inventory turnover–is attractive. Distribution companies can be very high growth, high profit firms. They can also have lost of operating leverage. WMT in its heyday is an example, as is any industrial wholesaler. Anyone fixated on high margins will miss this important class of firms completely.
What do I use instead of margins in projecting the income statement? I break down unit costs–labor, raw materials,…–as much as I can and forecast each. Some are simple functions of unit volume. Many, however, like advertising, administration, or sometimes labor, are relatively unchanged as volume increases. That’s where operating leverage and earnings surprises lie.