How to interpret profit margin

Let's say there are two coffee shops. One has a net profit of $1000, the other has a net profit of $100. Which coffee shop do you think has better profitability?

Wait…To answer this question, you first need to figure out what is profit margin.  

To put it simply: profit margin is an indicator that measures a company's profitability. It shows whether a company is doing well in turning its revenues into profits.

You may have seen several types of profit margins, among which gross margin, operating margin, and net margin are the most commonly seen ones.

Understanding the three types of margins is important in investing.  Each one of them reflects a company's business operation from a different dimension.

Let's start with the gross margin. It is the gross profit divided by the total revenue.

The gross margin tells us how efficient a company’s production process is. Generally, the higher the gross margin, the more competitive a company is in its industry.

It’s worth noting that gross margins may vary greatly from industry to industry. Some industries tend to present higher gross margins, such as the software industry, while others like supermarkets may deliver lower gross margins. In other words, a low gross margin doesn't necessarily mean the company is doing badly.

Now let’s take a look at the operating margin. Operating margin is calculated by dividing operating income by total revenue.

It measures how well a company manages its indirect costs.  Some commonly reported indirect costs include sales and marketing, general and administrative, and research and development expenses.

Generally speaking, if a company has a high gross margin but a relatively low operating margin, it could indicate high indirect expenses in areas like marketing campaigns.

The final thing we’ll look at is the net margin. Net margin is the ratio of net profits to total revenue.

Compared with operating margin, net margin puts more focus on a company's ability to manage interest and tax payments.

Net margin is perhaps the most important profitability indicator for many investors.

It shows whether a company has surplus profits that can be reinvested to drive future growth or distributed to shareholders in the form of dividends.

However, net margin may be affected by one-off items, such as asset sales, which will temporarily boost profits.

To sum up, by analyzing the gross, operating, and net margins, investors could get a clearer picture of a company’s operating strengths and weaknesses.