Among the important tools available to investors is ratio analysis. For example, we commonly, perhaps even unconsciously, use the price-earnings ratio as a way of evaluating a stock’s price and valuation.
How can we to make sense of ratios in a holistic way? Axel Tracy, a financial writer and teacher, takes on that challenge in his 2012 book, “Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet.”
According to Tracy, “This book aims at introducing the technique of ratio analysis, the concept of combining multiple aspects of the three [financial] statements (to form ratios) and then using the results to assess the success, or lack of it, of a business or investment.”
For value investors, ratio analysis should help us understand not only the data in an income statement, but also the overarching “story” being told by the financial statements. As Tracy explained at the beginning of his book:
"There is a key thing to remember before we dive into the ratios. The skill is termed 'Ratio Analysis' and NOT 'Ratio Calculation.' This means that the actual calculations and results are just the first step. In a way a doctor is presented with symptoms, he or she must analyze how all the symptoms fit together and then make a diagnosis and prognosis. This is also how you should approach ratio analysis."
Profit margin
The first of the profitability ratios he covers is the profit margin, a well known and frequently used metric. Its function is to tell an investor or potential investor how much profit a company gleaned from its sales, or what percentage of sales revenue is converted into profit.
This margin also tells investors how well the company is managing the costs incurred in generating those sales. Managing costs can be the difference between profits and losses. The profit margin helps tell investors how much pricing power a company has; in other words, the strength of its margins and its competitive advantage (aka its economic moat).
This is the formula for the profit margin ratio: Profit margin = Net income / Sales revenue. For example, net income ($1 million) divided by sales revenue ($10 million) = 10%. The information for this calculation can be found on the company's income statement.
What this means is that for every dollar in sales, 10 cents remains as profit while 90 cents is eaten up in expenses. The ratio for a particular period has some relevance, but its real power comes from trend analysis. Tracy wrote, “You can of course analyze one ratio against another or compare one company against another, but trend analysis is the best value for single ratio, single company analysis. This lesson applies to the ‘Profit Margin’ and all ratios that follow.”
If a profit margin is rising over time, one of two things is happening. One possibility is that either expenses are being reduced in relation to sales, or sales are growing at a faster rate than expenses. This may happen for many reasons, but most commonly it is either because of management’s control of costs or because the company has leveraged the economies of scale.
The second possibility for why the profit margin ratio may be rising is because the company has been able to increase its prices without triggering more expenses. In this case, the company may have perhaps developed premium products, improved its competitiveness or built a bigger base of loyal customers.
On the other hand, if the profit margin is falling, the opposites apply. Such regression may or may not be within management’s control. Tracy uses the example of airline companies and the price of jet fuel; when oil prices rise, airlines have no choice but to pay the going price.
While very useful, there are also drawbacks to the profit margin. Tracy begins with the challenge of comparing across industries. As he pointed out, it would be absurd to compare the profits margins of Apple (AAPL, Financial) and Chevron (CVX, Financial). Different industries naturally have higher or lower profit margins because of structural or bargaining power characteristics.
Different companies within an industry may use different strategies. Take two retailers, Walmart (WMT, Financial) and Tiffany & Co. (TIF, Financial), as an example. One is low-price and high-volume, while the other takes the opposite approach.
Therefore, a falling profit margin may reflect a changed business strategy, such as aiming to increase market share and hopefully offsetting that with an increase in scale.
Tracy wound up his analysis of profit margins with this point:
"Would you rather have the dividends from owning a business that had a 40% profit margin on $100 in revenue, or a business (in the same industry) that had a 10% profit margin on $1,000,000 in revenue? There is simply no way to tell the business strategy from the Profit Margin alone. But on a positive note, if you can learn the strategy of the business then you can break down this weakness and, better yet, test management’s implementation of that strategy with profit margin (and other ratio) analysis."
Conclusion
Tracy has started his book, “Ratio Analysis Fundamentals,” with an examination of the profit margin - what it can tell us about a company and what it cannot.
Derived from the income statement, the profit margin helps investors understand the relationship between a company’s sales and expenses, its pricing power, profit margins and competitive advantages. However, the ratio is of little value in comparing companies in different industries.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Beating the Street: 25 Golden Rules
- Beating the Street: Peter Lynch on Cyclical Stocks
- Beating the Street: 'Great Companies in Lousy Industries'
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