Profit Margins: The 5th Element of The Buffett Way
The subject of this last chapter is profit margin, a concept which is often not used in the most effective way for an investor’s benefit. That said, it is still a digit frequently quoted and looked at by many investors when making investment decisions. The reasons behind this are explored.
Before answering this question, I will outline what a profit margin actually means just in case some people are not aware of the concept. Profit margins are obtained by dividing net income by net sales. This essentially shows what percentage of net sales becomes net income after taking into account expenses (including tax).
As a result, a high percentage (high profit margin) simply indicates costs are being controlled well by management. This is what all investors would want to see in a company. The opposite is also true. A low percentage (low profit margin) is largely negative and implies that an increased in costs could potentially eliminate profits and create net losses for the company.
The above explanation clearly demonstrates how advantageous it can be to be aware of the profit margins of a company. Nevertheless, Warren Buffett has his own way of using profit margins which have brought him so much success over the years.
Historical profit margins are the key behind the success Buffett has enjoyed. This basically means that you have to analyse the evolution of profit margins of a company to give you a good idea of the state of the company. During this analysis, 3 types of patterns can be observed and it’s important to understand the meaning of each one.
The first type of pattern is a consistent profit margin. This basically means that in the last 5 years (or whatever number of years you choose to use) the profit margin has remained relatively stable. This is good news if the profit margin is high means that management has successfully been able to control any growth in expenses. However, it is bad news for any investor if this is low.
Another typical pattern observed is one where the profit margin has steadily increased during your elected analysis time frame. This implies that the company has managed to control expenses so well to the point that they have been falling with each sale. Nevertheless, you should still look at the other component of the Warren Buffett methodology, indicated in my previous articles before making any decision.
A third typical pattern observed is one where the profit margin has steadily decreased during your elected analysis time frame. This implies that the company has been unsuccessful in controlling rising expenses over time and is largely negative news for investors. That said, it would still be wise to look at the other 4 component of the Buffett methodology before making a final definitive decision.
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.
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