Profit Margins: As Vital as Profits!

Investors track profits while analysing stocks, but tend to ignore profit margins at times. Profit margins reveal the real financial situation of the company and studying the trend in profit margins should be an integral part of any investment process. Geyatee Deshpande emphasizes the importance of profit margins and reveals those sectors that display above average profit margins.



While choosing a company for investments, a fundamental investor looks at several factors. Most investors will focus on sales growth, profit growth, balance sheet quality, leverage, management pedigree, etc. but very few will study the trend in profit margins while analysing stocks. While it goes without saying that a high margin business should be preferred over a low margin business, there are several other considerations that will influence the buying decision.

There could be instances where we might see the stock prices inching up faster for those companies with lower operating profit margins than to those with higher operating profit margins. This could happen where the low profit margin company is able to grow at the faster rate (absolute PAT growth) than the company with higher profit margins.



The table highlights performance of three stocks from the same industry viz., FMCG – consumer foods. We can see that the PAT margin for Varun Beverages is the lowest at 8.61 per cent for FY18 when compared to that of 12.94 per cent for ADF Foods and an impressive 50.51 per cent for Zydus Wellness. However, the PAT growth is maximum for ADF Foods, followed by Varun Beverages. Thus, despite operating at lower margins, Varun Beverages and ADF Foods have done better on the bourses due to higher PAT growth. However these are exceptions. In normal circumstances higher operating profit margin companies should outperform lower operating proft margin companies in long run.

What is Profit Margin?

In accounting and finance, a profit margin is a measure of a company’s earnings (or profits) relative to its revenue. The three main profit margin metrics are gross profit margin (total revenue minus cost of goods sold (COGS) ), operating profit margin (revenue minus COGS and operating expenses), and net profit margin also known as PAT margins (revenue minus all expenses, including interest and taxes).

Why focus on profit margins while analysing stocks
Any investor undertakes risk while investing in stocks. The risk undertaken increases significantly when the stock selection goes wrong. The stock selection can go wrong when an investor opts to bet on those stocks that are consistently showing declining profit margin trend over the years. What a declining margin trend indicates is that the strategy adopted by the company is not working for the company and that the company is not able to manage its costs efficiently. The margins may shrink also because the demand for products and services is waning. Such a situation does not augur well for the financial health of the company and can impact stock prices negatively.

Success in identifying an outperforming stock depends on how an investor treats a low margin stock versus a high margin stock. If an investor chooses a low margin stock in the same industry over a high margin stock, there has to be a strong reason for doing so. One of the active risks an investor takes while betting on low profit margin business is that during periods of economic slowdown and intense competition, the company may struggle to remain profitable even as its competitor with higher profit margins will be able to survive profitably. A company may be growing at a decent rate; however, it may be operating with wafer-thin margins, which may evaporate with higher raw material prices, etc. One has to be extra careful while choosing low profit margin companies instead of high profit margin companies.

High profit margin companies are the ones that can increase prices to cover the rising cost of labour, raw materials and other operating expenses. These businesses with high profit margins can reduce their prices and still remain profitable. Such flexibility allows them to respond to competition or reduced buying power of their customers.

Thus, choosing a company for long term investments keeping in mind the operating profit margin and net profit margin trend is essential and should be the core aspect of any investment process. The trends in operating profits margins and net profit margins talk a lot about the strategy of the company and the company’s ability to grow profitably.

PAT v/s OPM

While analysing a stock, most investors focus on net income or profit after tax (PAT) as it is PAT that determines the dividend payout which, in turn, impacts the stock's valuation.

However, an investor should know how the net income is arrived at and that companies should not be judged by their net profits alone. The focus should be on operating profits and the operating profit margins as well. It is possible that a company is profitable at the PAT level, but it is making losses at the operational level. In other words, the company is able to declare profits, i.e PAT, only because it has income from other sources, i.e., apart from its operational income.

The total income for any company will include both operational income and non-operational income. Operational income is the core earnings generated by selling the goods and services of the company. Higher operational income reflects strength of the company and should be discounted positively while valuing a company. Other income is the revenue generated in the form of rent, interest, dividends or foreign exchange gains.

While valuing a company, investors cannot afford to ignore the other income component. However, a consistent growth in core earnings is what should excite long term investors. For most companies, the other income or non-operational income is temporary. A consistent drop in operational income and operation income margins reflects that the demand for the company’s products and services is shrinking. Therefore, it will be risky for long term investors to bet on such stocks.



I N T E R V I E W

Dinesh Thakkar,
CMD, Tradebulls Securities


How important is studying margins while analysing any stock?

If one buys a stock of a certain company and profit grows for the next few years, then one will be treated to a rising share price, but if the company does poorly over the next few years, the shares will lose value. While this concept may sound simple, it's surprising how many investors overlook the key indicators about a company before investing. Margin is one such important indicator. Margins help one determine the financial safety of the company after accounting for costs and expenses. Most common margin ratios used by investors for evaluating a company are the operating margin and net profit margin. Operating margin is not directly related to the cost of production, but it determines how well the company has controlled its costs, which include selling, distribution and advertising. The net profit margin is self-explanatory and it is money left after deducting all expenses. It is very important to study the company's margin while analysing a stock as it gives idea about the company's stability and its efficiency. For instance, companies with growing profit margins signal that the company can command higher prices even during the recession because consumers are willing to pay for its products. Companies maintaining steady profit margins show that the company can effectively control its operational cost and be cost-efficient. Steady or growing margins indicate that the company is stable and will reward shareholders with steady returns.

Is there any correlation between high profit margin companies and stock returns?

There is a positive correlation between high profit margin companies and stock returns, but there are other factors that have to be considered too. Yes, it is true that companies with high or rising net profit margins are efficient and better equipped to survive economic contractions which will result in positive returns. But one can never look at a single factor in isolation to tell what is going to happen in a particular stock looking at the margin. Inflation, economic environment, allocation preferences, interest rates, demographics, etc. are other factors that have to be considered. Otherwise, Apple company known for high profit margin would not have given a negative return last month. For the long term, companies with high profit margin are a good investment, but for the short term, investors should figure out how much they are willing to pay for the current or future profits.

Margins – sector-wise

One of the best ways to identify profitable stocks is to first identify the sectors that are relatively more profitable. If one can identify those sectors where, on an average, the profit margins are higher, identifying individual stocks with higher margins and better growth prospects will be an easier task.

If we consider the BSE 500 components and take into account the profit margins across sectors, we find that financials is one sector that operates on higher profit margins, followed by IT, power, FMCG and chemicals. These are the sectors where, on an average, the PAT margins are higher than 10 per cent. The sectors that are seen struggling on the profit margin front are engineering, healthcare, construction, auto and textiles. Going by the data in the table below, investors can focus on those sectors where, on an average, the PAT margins are greater than 10.



Consistency in PAT margins

Now that we know the importance of higher margins in stocks, we should also focus on the consistency of the PAT margin. We find that stocks that have shown consistent improvement in margins are the ones that can outperform the benchmark indices.



Above table highlights the list of BSE 500 constituents that have shown improvement in margins in all of their previous four quarters. Stocks like Teamlease Services have outperformed BSE 500 by almost 4 times, while DCB Bank and Oriental Bank of Commerce outperformed by nearly 3 times. Out of 500 stocks, we find that there are merely 11 companies that displayed improvement in PAT margin in all of the recent four quarters.

I N T E R V I E W

Mustafa Nadeem,
CEO, Epic Research

"Smart Money Keeps Flowing Into High Profit Margin Stocks"


Which sectors' stocks have always enjoyed high operating margins?

The sectors that usually have a high operating margin is usually dominated by a few handful of companies. These companies tend to generate high profit in their specific sector and hence maintain the leadership.

NBFCs, consumption, dyes and pigments, chemicals, pesticides and agro-chemicals, fertilizers, electric components, oil explorations and refineries are the few sectors that have enjoyed high operating margins and the stocks are traded with high premium as well.

Do these high-profit margin stocks always outperform?

Yes, they do, in the long run. These companies firstly eat up a large portion of the profits that are generated in that sector or space. Secondly, this gives them an edge in the long run, since there is a clear double-digit growth in most of the stocks. Money likes to move into stocks or space that will see good growth in the future, irrespective of the fact if the price is costly or valuations are high. The fact is that there is a consistency in smart money that keeps flowing into these stocks on any decline.

Even if the company is from PSU space with a good track record, it tends to add value to the portfolio through dividends. For example, ONGC has been continuously giving dividends on an average above 40% in the last 10 quarters. The choice of investor/ trader in terms of growth here has to be specific.



Look for companies with high profit margins.
-Warren Buffett




Conclusion

While it is true that, in the long run, the earnings (net profits) drive the stock prices, there is a lot to learn about the companies while studying their profit margin trends. A deeper look into the profit margins of stocks under consideration can reveal a lot about the company. To begin with, investors can start by identifying those sectors which enjoy above average margins. By identifying such profitable sectors, chances are you will find multiple investing opportunities with individual stocks that enjoy higher profit margins. Financial is one sector which enjoys profit margins way above the other sectors. Identifying opportunities in such sector which enjoys higher profit margins will lead investors towards tapping more profitable opportunities. It is possible that a company enjoys above average profits and yet the trend is that of diminishing margins over the years. In such cases, there is always a possibility that the company may struggle to remain profitable in the future. The downward trend in profit margins should be used as a red flag while analysing stocks, unless there are other compensating factors, such as higher profit growth, etc.

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