The Three Main Types of Profitability Margins

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It is always a good idea to define the types of profit margins presented in a management’s speech or a company’s presentation.

 

Profit margins are useful for determining and comparing against its peers how much profits a company is making as a percentage of revenue it earns after subtracting certain costs; different profit margins are adjusted for various expenses in the income statement. Sometimes, profit margin analysis can be used in conjunction with other profit ratios such as the ROE or ROA. To measure profitability margins, there are basically three different types one should know.

 

Gross Profit Margin

 

Gross Profit Margin (GPM) = (Revenue – Cost of Goods Sold) / Revenue

 

Gross profit is derived after subtracting a company’s cost of goods sold (COGS). COGS is an aggregate expenses from direct labor, raw materials and other overheads costs such as utilities (e.g. power bill of a manufacturing plant)involved in the manufacturing of products. The gross profit margin is able to tell us whether companies have control over supply costs and/or whether they have a strong product differentiation which allows strong pricing power. For example, Super Group  Ltd (SGX: S10) has S$557 million of revenue and S$209 million of gross profits earned in 2013. Gross profit margin is thus 37.5%.

 

Operating Profit Margin

 

Operating Profit Margin (OPM) = (Gross profit – selling & distribution costs – general administrative costs) / Revenue

 

Also known as EBIT (earnings before interest and taxes), operating profits show the residual earnings after subtracting out most of the fixed costs (i.e. staff costs, rental expenses, advertising & marketing costs, research & development costs). As a company with a large economics of scale grows its sales revenue, fixed costs should become a smaller percentage of total costs and operating profit margin should increase. A high operating profit margin might also suggest a firm has a low-cost operating model. For example, Texhong Textile Ltd (HKSE: 2678.HK) has RMB1.36 billion of operating profits earned. However, we have to exclude its other income gains of RMBRMB316 million as it is not part of its core business earnings.  As such, based on its revenue of RMB8.23 billion in 2013, the Group’s operating profit margins stood at 12.6%.

 

Net Profit Margin

 

Net Profit Margin (NPM) = (Operating profit – interest expenses – tax expenses) / Revenue

The bottom-line. Net profit measures the profitability of a business after accounting for all its costs. Its net profit margin would indicate how much after-tax profit would a business make for every dollar of revenue generated.

 

Value In Action

Profit margins vary by industry and can be used to compare against peers or used to analyze historical trends. Knowing by definition the different levels of profit margins allow investors to understand how company control its internal costs or whether their products have pricing power.

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All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie does not own any shares in the companies mentioned above.

 

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