Profit Margin

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This column covers fundamental analysis, which involves examining a company’s financial statements and evaluating its operations. The analysis concentrates only on variables directly related to the company itself, rather than the stock’s price movement or the overall state of the market.

Profit Margin
Anal
ysis
A company’s stock price, in large
part, is driven by the company’s ability to generate earnings. Therefore, it is useful for investors to analyze
the profitability of a company before
investing in it. One way to do this is
by calculating and tracking various
profit margins, which reflect how efficiently a company uses its resources. Profit margins are expressed as
a ratio, specifically “earnings” as a
percentage of sales. By expressing
margins as a percentage, we are able
to compare the profitability of different companies more easily. Margins allow investors to judge, over time,
management’s ability to manage costs
and expenses and to generate profits. Management’s success or failure determines the company’s profitability.
Strong sales growth is meaningless if
management allows costs and expenses to grow disproportionately. In this Fundamental Focus, we
highlight three key profit margin
ratios—gross profit margin, operating
profit margin and net profit margin.

Gross Profit Margin
The gross profit margin (gross margin) measures the profit a company

makes from its cost of goods sold
(cost of sales). Cost of sales represents expense related to labor, raw materials and manufacturing overhead used in the production process. This ratio measures how efficiently
management uses labor and raw materials in the production process, and it is calculated as follows:
Gross profit margin = (sales – cost of goods
sold) ÷ sales

A company uses its gross income
to fund such company activities
as research and development and
marketing, which are important for
generating future sales. A prolonged
decline in the gross profit margin is a
red flag for possible impending negative pressure on sales and, ultimately, earnings.
Trends in the gross margin reflect a
company’s basic pricing decisions and
material costs. However, management
generally cannot exercise complete
control over these costs. Rising labor
costs and raw materials costs will cut
into a company’s gross profit margin
if the firm cannot pass these rising
costs onto its customers in the form
of higher prices.
Note that not all firms disclose
their cost of goods sold on their
income statements, notably financial

Table 1. Comparing Profit Margins
Gross Profit Margin (%)
AMR Corporation (AMR)
Delta Air Lines, Inc. (DAL)
Southwest Airlines Co. (LUV)
Airline industry median

Current 2010
18.5
18.6
18.3
19.3
25.2
25.1
25.2
25.8

2009
15.5
11.3
21.4
22.4

2008
15.0
10.8
22.1
21.0

2007
21.8
17.2
26.6
25.6

2006
21.7
10.4
30.5
26.4

Operating Profit Margin (%) Current 2010
AMR Corporation (AMR)
1.7
1.4
Delta Air Lines, Inc. (DAL)
5.0
5.8
Southwest Airlines Co. (LUV)
8.3
8.2
Airline industry median
3.9
6.8

2009
(5.0)
(1.5)
2.5
3.7

2008
(7.9)
(36.6)
4.1
3.7

2007
4.2
12.1
8.0
6.0

2006
4.7
(35.1)
10.3
6.8

Net Profit Margin (%)
AMR Corporation (AMR)
Delta Air Lines, Inc. (DAL)
Southwest Airlines Co. (LUV)
Airline industry median

2009
(7.4)
(4.4)
1.0
1.0

2008
(8.9)
(39.3)
1.6
0.8

2007
2.0
8.4
6.5
3.6

2006 2005 2004
1.0
(4.1)
(4.0)
(35.4) (23.3) (34.2)
5.5
6.4
3.3
4.0
3.0
3.3

Current 2010
(1.8)
(2.1)
1.6
1.9
3.6
3.8
3.5
3.7

Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of May 6, 2011.

20

2005
18.8
5.2
31.6
24.1

2004
19.0
9.3
29.0
28.7

2005 2004
(0.4) (0.7)
(17.5) (21.9)
9.6
6.2
4.6
6.2

and other service-related companies.
In such instances it is not possible to
calculate the company’s gross profit
margin.

Operating Profit Margin
The operating profit margin (operating margin) compares a...
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