Running a business is all about making a profit, so it makes sense that one of the best measures of a company's performance is its profit margins.
Strong profit margins almost always mean a company is well-run, stable, and making money.
A company with healthy profit margins indicates it is efficient at allocating capital and controlling costs, so it can deliver more revenue to the bottom line.
It also means the business has built-in safety. Therefore, a sales slump is less likely to cause an operating loss.
And if a company can maintain strong profit margins year after year against competitors in the same industry, that's as good as it gets.
For investors, what all this means is that finding the companies with the best profit margins is a great way to identify promising stocks.
Let's dig into this topic a bit deeper so you know just what you need to look for.
Let's start with a simple definition. Simply put, the profit margin is the amount of money a company earns from each dollar of sales, usually expressed as a ratio, or percentage.
And be sure not to confuse sales and earnings with profits. That can get you into trouble, because if sales and earnings are growing while profit margins are thin or nonexistent, the company could be getting ready to fold its tent.
The reason profit margins matter so much is because they reveal how much money management is squeezing from total sales.
Profit margins are also great for comparing the profitability of different companies - something not possible with sales and earnings figures.
What's more, measuring profit margins from one year to the next can determine if the company has gained or lost ground against its competitors or weathered a difficult economic period.
If a company can maintain the same margins from one year to the next in spite of adverse conditions, it's an indication the company is here to stay. But watch out if the company has lost ground.
Great businesses often have lengthy track records of consistent profit margins and tend to have strong pricing power for their products, making their goods more attractive.
Now, here's what to do as an investor...
Right now, optimism on Main Street is high.
Investors poured $57.6 billion into stock funds and exchange-traded funds in July as the market hit new all-time highs, according to Lipper.
But while revenue growth has been strong in 2013, profit margins have only improved slightly.
The fact is, companies have spent the last five years squeezing out extra earnings with aggressive cost-cutting and productivity gains. That means few opportunities remain for easy earnings gains through cost-cutting strategies.
Meanwhile, Wall Street projections are flashing a warning sign for investors...
According to a recent analysis in Barron's, consensus estimate on Wall Street assumes earnings will more than double, to 10.5%, in the fourth quarter - but fourth-quarter sales are expected to grow only 0.6%.
"Where's that margin growth going to come from? More layoffs? Productivity gains? Most of us aren't exactly napping on the job as it is...forecasts look very optimistic," Howard Silverblatt, chief index analyst at S&P, told Barron's.
In other words, overall margins are shrinking right now, making the market pricey.
This is especially true for a couple of sectors, like the consumer discretionary and telecom sectors, as Barron's pointed out. The technology and healthcare sectors appear to be on safer ground.
There are a couple things investors can do to find companies with the best sustainable profit margins.
Investors should first calculate a firm's after-tax profit margin by dividing its net income by sales.
Do the same for the firm's competitors, and look for companies with the best profit-to-sales ratios in that industry. Margins should be rising quarter after quarter and year over year.
By way of example, let's take a look at three solid companies with some of the best profit margins in their sectors:
Now that you know where to invest, find out how to protect your profits ahead of a volatile market: How to Invest in a Market Correction
Related Articles: