Screening Your Way to Profits Using “Net Profit Margin”
When looking at potential investments, one of the keys is finding companies with profitability. Companies that consistently grow their profits have the best chance to grow in share price… today we are going to put net profit margin to work.
Stock screens are one of the best ways to find new investment ideas. Over the last couple of weeks we have added two metrics, P/E ratio and P/B ratio, to your screen that help you assess the value of a company based on earnings and book value.
While both of these metrics are very useful in finding the value of a stock in relation to a company’s earnings and assets… one very important aspect is left out.
Neither one of these ratios tells you how much money the company is actually bringing in as profit. To find out how profitable a company is, today I want to introduce you to the net profit margin.
The net profit margin can be found by taking a company’s net income and dividing it by a company’s revenues.
Revenue is the entire amount of money a company receives from sales before any deductions. Net income is the company’s revenue subtracting out costs and expenses. Simply put, revenue is your salary, and net income is your spending money after your bills and other necessary expenses are paid. The net profit margin measures how much out of every dollar in sales the company keeps as earnings and is shown as a percentage.
Finding a company’s net profit margin is a great way to look at a company’s profitability. Many investors could be tempted to look at a company’s net profits alone, but this would not give them the full picture.
The net profit margin doesn’t just give you a quick look into what a company takes home in profits at the end of the day… it also gives you deeper insight into the efficiency of the management.
For example, you have two companies: Company A brought in $1 million in sales while Company B brought in $2 million. At first glance most may say that Company B would be the better investment because in brought in twice the amount in revenue as Company A.
But, after subtracting out costs (such as salaries and other operating expenses) both Company A and B have a net income of $200,000. Even though Company A brought in less revenue they keep 20% of every dollar they bring in and Company B only keeps 10%. After looking at the net profit margin one can clearly see that Company A is the more profitable company.
One can also assume that Company A is managing their resources well. Their relative costs are a lot less compared to Company B… by that measure Company A is running more efficiently; they are spending less and therefore keeping more of the money they are bringing in.
So what does net profit margin mean to you as an investor?
A lower net profit margin can indicate a low margin of safety. Because the company is bringing in less income from its operations, in times of economic downturns it could be more likely to start losing money.
It is important to note however that for companies with fast moving inventory, like grocery stores, lower profit margins can be acceptable. Many retailers have a low cost, high volume approach that could cause lower net profit margins.
Companies with higher net profit margins show good indication that the company is doing well. The higher the net profit margin, the more money a company is making compared to their expenses.
More importantly, companies that are able to grow their net profit margins will usually be rewarded over time with growth in share price— especially when they pass those profits onto shareholders in the form of dividends or share buybacks.
For our screen, to narrow our focus to small-cap companies with reasonable levels of profitability, we will set the net profit margin to greater than 10%.
Here is a look at our stock screen so far:
We are now left with about 40 small-companies that are showing the profits for growth.
Just like the other metrics we have discussed, the net profit margin should not be used alone and can vary by industry. It is always important when evaluating stocks to make sure you are comparing the companies with their industry average (which can be easily found on Yahoo Finance by clicking on “Competitors”).
We are quickly narrowing down a very manageable watch list of stocks. Next week we will add free cash flow to our Sleuth screen.
February 18, 2011
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