Warren Buffett & The Importance of Profit Margins

Posted by Martin Sejas

Profit margin is the theme of this final article in the series about Value Investing which is a concept that is commonly underutilised in finance today. Nevertheless, profit margin is something that all investors tend to look at when decide which stocks to invest in. The reasons behind must be understood.

However, before I can explain the reasons, it’s important to define the term profit margin given that many people are still bewildered by its meaning. Simply put, it is the percentage of net sales that becomes net income after subtracting expenses which includes tax.

Therefore, a high profit margin means that the company is controlling its costs very well, which is what investors all look for. On the other hand, a low profit margin indicates a low margin of safety meaning that a decline in sales could quickly erase profits and result in a net loss.

Now, that all may seem pretty simple to understand, which is true. It’s not difficult to see how profit margins can be useful in determining which companies to invest in. However, Warren Buffett uses profit margins in a different way to the typical investor and this is why his fortunes have not been necessarily typical.

The master’s technique is basically focused on looking at the history of profit margins of a company, whether it be 5, 10 or 20 years. A recommended time frame would be 5 years which should give you a good indication of profit margins have changed since. There are 3 patterns that should be observed, all of which are detailed in the following paragraphs.

One common pattern is a profit margin that is stable over the time period you have chosen, whether it be 5, 10 or 20 years. Overall, if this number is high it indicates that the company has been successful in controlling changes in expenses. If it is low, then controlling expenses is still a challenge for the company.

The second type of pattern is an increasing profit margin. This basically means that in your chosen period, the profit margin has steadily increased. This is great news for a budding investor, however, before choosing to invest in such a company, it’s recommended that you completely understand the other components of Buffett’s methodology before making a decision which are explained in my previous articles.

The third type of pattern is a decreasing profit margin. This basically means that in your chosen period, the profit margins have steadily decreased. This is certainly not good news for any investor because it means that management has not been able to control increasing costs over time. However, as I said before, any company should not be discarded without analysing the company using other components of Buffett’s methodology.

In conclusion, the methodology used successfully by Buffett is something that all investors should study, all of which are outlined in this article and the preceding articles. One would be crazy to not learn something from the richest man in the world. However, there are many other strategies out there which have been successful. Watch this space for many more great articles on stock trading strategies.

Tags: Finance

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