Evaluating Company Profitability

Gross Profit & Gross Margin

The gross profit (also known as gross operating profit) is the sales or revenue lesscost of goods sold (COGS). This number divided by sales is the gross margin (in percentage terms). It is represented mathematically as follows:

Gross Profit = Sales - COGS
Gross Margin = Gross Profit*100/Sales

The calculations above, as with most of the calculations in this website, are simple. But it is important that you understand the information you can get out of the numbers. What gross margin tells you is how profitable the business is before subtracting SGA, R&D, and ITD expenses.

You are likely to see high gross margins for technology and Internet companies. For example, Microsoft Corporation's gross margin was around 90% at the time of this writing. This means that for every $1 Microsoft gets from customers, it keeps 90 cents and spends 10 cents to deliver its products or services to the customer (although the 90 cents it keeps for each dollar it takes in still has to be reduced by other indirect costs of doing business such as SG&A, R&D, and ITD). PepsiCo and Motorola Inc. had gross margins of approximately 64% and 38%, respectively, at the time of this writing.

We recommend that if Teenvestors are looking at large-cap companies, they stick to companies that have gross margins of 35% or more, unless the company is very solid in all other ways discussed in this section. For medium-capitalization firms, stick to gross margins of over 50% unless the companies have other strong features.

Operating Profit & Operating Margin

In the section above, we calculated gross profit as sales less the cost of sales. Recall that gross profit does not consider some other expenses incurred by the company that are not directly related to the items the company sold such as SG&A, R&D, and ITD. When SGAs and R&D costs are subtracted from gross profit, we get operating profit. Operating profit divided by sales is the operating margin (in percentage terms). Here is the mathematical representation of the calculations:

Operating Profit = Gross Profit - SGA - R&D
Operating Margin = Operating Profit*100/Sales

The operating margins for Microsoft Corporation, PepsiCo Inc., and Motorola Inc., were approximately 49.5%, 13.8%, and 3.8% at the time of this writing.

Net Profit & Profit Margin

The only reason most companies exist is to make money. Net profit (sometimes referred to as net income , net earning , or just plain earnings ) is how much profit a company makes after subtracting all its expenses. Mathematically, net profit is calculated as follows:

Net Profit = Sales - COGS - SG&A- R&D-ITD

Where 1) COGS is cost of goods sold, 2) SG&A are the selling, general and administrative expenses, 3) R&D are the research and development expenses, and 4) ITD are the interest, taxes and depreciation expenses.

When all is said and done, stock prices increase because of growing company net profits or because of the anticipation of earnings.

When a company's net profit grows, the investor has a better chance of receiving dividends (if the company pays dividends at all), the retained earnings grows (meaning that more money is plowed back into the company), and other investors are attracted to the company because of its success (thereby driving the stock price higher).

In the world of investing, companies whose net profit grows each year from 10-20% (or more) are considered growth stocks. For our purposes, if a company's profit has increased by 10% or more over the past 5 years, and is expected to increase by about the same amount next year, you can consider it a growth stock.

Some companies that have no earnings can still make for good investments because of the anticipation of earnings. This is the only reason why some new technology and Internet companies do well from the standpoint of their stock prices. These companies typically have losses for years as they spend a lot of money to develop their technologies. But what investors are betting on is that some time in the future, they will start making money because of the technical superiority or the uniqueness of their products.

Once you have calculated net profit you can then calculate profit margin (also known as net margin or net profit margin ), which is given in percentage terms as follows:

Profit Margin = Net Profit * 100/Sales

While net profit numbers are important, profit margins are even more significant because they can tell you how much money a company actually keeps for each dollar it gets from its customers after paying absolutely all its expenses. The profit margins for Microsoft Corporation, PepsiCo, and Motorola, were 39.4%, 10.1%, and 2.6% at the time of this writing.

As with some other fundamental analysis measures, it pays to calculate net profit margin over time to see if it is steady, going down, or increasing. Ideally, you would want net profit margin to go up or stay steady. A declining profit margin is not good unless there are some unusual circumstances that caused it.

For example, when a company closes a manufacturing plant, there are usually some extra expenses associated with giving the workers severance pay -- money workers are paid when they are fired or laid off. In the year these workers are fired or laid off, the company's expenses will increase by the severance pay. But these expenses will not show up on the company's income statement in the next year so there is no reason for alarm when the decrease in profit margin is because of an unusual expense item.

Some industries, such as retail clothing and electronic stores, have low profit margins. For this reason, no one can really tell you the minimum profit margin you should seek for the company whose stock you are considering buying. What's fair to say is that if you are interested in a particular industry, choose the companies in that industry that have the highest profit margins.