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Net Margin: a Measure of Accounting Profitability

Net margin, also called net profit margin, is a measure of a company’s accounting profitability, i.e. profits reported on the income statement.

Net margin compares a company’s net earnings, or net income, to its revenues or sales.

How to Calculate Net Margin

To calculate a company’s net margin, divide net earnings by sales.

For example, Microsoft reported 2021 net earnings of $61.3 billion, and sales of $168.1 billion, resulting in a net margin of 36.5%.

What’s a Good Net Margin?

As Pat Dorsey describes in his book The Five Rules for Successful Stock Investing, as a rule of thumb, companies with consistent net margins above 5-7% are highly profitable and likely have an economic moat that can keep competitors from taking away profits.

Note, however, that there are exceptions. Some companies consistently show low net margins, and yet are highly successful. An example is retailer Costco (COST).

How to Use Net Margin for Investment Decisions

Similar to other financial metrics, a company’s current net margin should be compared in two ways:

  1. Historic comparison: compare to at least 5-10 years of historic net margins
  2. Competitor comparison: compare to competitors in the same industry

These comparisons have two benefits: they allow us to identify companies with consistently high profitability, and we get an idea about the profitability of an industry as a whole.

Comparison to Historic Net Margins

Comparing the current net margin to previous years can reveal whether a company has been profitable for many consecutive years. This is typically indicative of an economic moat.

An example of such a company is Alphabet (GOOG). Over the past decade, Alphabet has shown that it can consistently report high net margins of ~20%, with a dip only in 2017.

Data source: Morningstar

Another scenario could be a cyclical business with fluctuating net margins. In good times, such a company will generate larger profits than during bad times. This doesn’t mean that a company cannot have a wide moat, however. An example is wide-moat company Caterpillar.

Comparison of Net Margins Amongst Competitors

Another way to look at a company’s net margins is to compare them to competitors in the same industry.

Let’s look at the internet retail/technology sector. Microsoft (MSFT), Apple (AAPL) and Alphabet (GOOG) reported net margins consistently above 10%. Apple even above 20%. And Microsoft over the last three years even above 30%.

Contrast that with Amazon (AMZN), which keeps hovering around 0 to 5%. Despite the low net margins, Amazon has a giant moat and several sources of competitive advantage. This shows that net margins alone are not necessarily indicative of economic moats. Other metrics are necessary.

Data source: Morningstar

An industry comparison can be very telling about the various companies’ operations and priorities.

It also highlights that looking at net margin alone is not sufficient to get the whole picture about a company, and whether it has a durable competitive advantage or not. Other metrics are necessary.

Compare Net Margin Trend with Operating Cash Flow

Finally, net margin represents how much a company can convert its sales into accounting profits.

However, accounting profits are susceptible to all kinds of accounting trickery such as one-off expenses that can mislead investors.

Operating cash flow is much harder to influence by accounting measures. It can be used as a gauge for cash profits and is listed on a company’s cash flow statement.

Therefore, it is always a good idea to compare a company’s net margin trend to its operating cash flows.

What to Look for

One of two trends show that a company is achieving actual profitability, not caused by accounting tricks:

  • Both lines show an upward trend
  • Net margins are flat, and operating cash flows are increasing

This is exactly what is shown by Microsoft, Apple, Alphabet and Amazon below.

Data source: Morningstar

What to Avoid

A red flag would be increasing or flat net margins while operating cash flows decrease year after year.

Conclusion

Net margin is a great way to assess a company’s accounting profits, i.e. net income as a percentage of sales.

As usual, we need to compare current numbers to historic and competitor numbers.

Also, to avoid falling into accounting traps that distort accounting profits, we can compare net margins to operating cash flows and look for similar trends.

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