What are margin ratios and how do you use them? If you are working toward learning how to invest in stocks, an important ratio to understand is margin ratios. Understanding margin ratios and using ratios in general to compare one stock to another will help someone learn how to invest in stocks. There are simply far too many stocks to choose from. Picking stocks would be a full-time job for any analyst. Given that, one of the tools you can use when you are learning how to invest in stocks is to compare ratios. Margin ratios are some of the most important ratios to compare.
First, what is a margin? A margin is a ratio in itself and it tells an analyst on a percentage basis how well a stock performed in a specific metric. For instance, gross margins are what percentage of the gross revenues a firm retains after cost of goods sold are deducted. After deducting cost of goods sold, the remaining amount is gross profits. Then, you divide gross profits over gross revenues. This metric gives an individual the ability to see what percentage of total revenue is retained after cost of goods are deducted.
Comparing Margin Ratio Metrics
Now that a you have a number, how good is that number? Until you find a benchmark to compare any one metric to another, the information is not necessarily useful for someone that is analyzing a stock.
In the above financials for Apple – APPL stock, for the quarter ending 9/25, revenue was $365,817,00. Gross profits were $152,836,000. To calculate gross margins, divide $152,836/$365,817 to get 0.4177936. This is 41.8% in gross margins.
Comparing The Company’s Results
There are actually three areas to compare this resulting number and, they are all important. The first place to compare the number is to the company itself. If you have one quarter’s results, have the results improved from one quarter to another?
What you are looking for here is a general trending of data points that lead the analyst to believe that the company is either performing better or worse. Comparing numbers from one period of time, be it a quarter, or a year, tells whether the company is seeing an upward or downward trend.
Note, however, if a company is performing worse in one period of time versus another, it is important to understand why. Is there some issue affecting the company itself, or is there a broader, economic issue that is contracting the numbers for any one company. If the economy is contracting, but the company itself is generally a company that performs well, likely the stock is declining because of the contraction in its metrics. But, so will, too, the entire stock market. If so, this may signal a buying opportunity in the future.
Comparing the Company to the sector & index
There are two major areas that an analyst can use to compare metrics:
- Other Sector Stocks
The broader indexes are an excellent starting point for comparing metrics. Indexes are groups of stocks that are combined to give a performance metric of all stocks in that group. For instance, the Dow Jones Industrial Average, or The Dow as it is commonly referred to, has 30 stocks that broadly represent the overall US economy. The S&P500 is an index of 500 stocks that represents the same.
There are a total of 11 sectors within the investing world. Many stocks within an individual sector, such as the Technology sector, perform closely to each other. If an investor believed that an individual sector would outperform the broader indexes, they may want to target and compare stocks within that sector.
Then, comparing metrics to each stock would allow an analyst to see which stock potentially could outperform another stock. Using a metric to compare one stock to another could show that one respective stock is going to outperform another.
More than just a number
Simply because one metric is higher, or lower, than another company’s metric does not necessarily mean that one company’s stock will outperform another. For instance, if gross margins for one firm are coming in at about 40%, whereas the general industry is much higher at 45%, this does not mean that the respective stock will not perform as well.
What is also important to note is where any company is with regard to its life cycle. If the firm is just starting up and margins are accelerating quickly, would it be possible that the firm’s performance could surpass the performance metric of the overall industry?
This is the job of the analyst to determine by looking in to the particular growth rate of the respective company and then determining if this is a possibility.
Another factor to consider is that stocks, and investing, is a popularity contest. Despite how well a company’s stock could perform, if no other investors have stepped into the fray and continuously acquired the stock driving up the price, then that stock may be doomed to mediocrity. This is something to consider and is key to understanding how to invest in stocks.
Other Margin Ratios
Above, gross margins were mentioned. But, there are two other margins that are equally important as you move down the financial statements. In the financial statements, starting with gross revenues, you subtract cost of goods sold to come up with gross profits. Gross margins, are of course, gross profits divided over top of gross revenues.
Operating Profits & Operating Margins
The next section of the financial statements is the operating costs section (followed by the continuing costs section). From gross profits, total operating costs are deducted. This gives operating profits. Then, to find operating profits ratio, an analyst would divide operating profits over top of gross revenues.
This percentage tells how much of revenue is retained by a firm after cost of goods sold as well as operating costs are deducted from gross revenues. And, the metric, as a percentage, tells an analyst how well one company performs. Comparing this resulting number will enable the analyst to see how well this company performs in this segment of its financial statements.
In the example above for Apple, operating profits – or, operating income – were $108,949,000. Divide that by gross revenues of $365,817,000 to get 0.2978, or 29.8% operating margins.
Continuing Costs & Net Earnings
Lastly, the next portion of the financial statements are continuing costs. These costs are costs generally associated with financing a company’s endeavors. And, they are generally the last costs deducted from gross revenues. After cost of goods sold, and after total operating costs are deducted, continuing costs are deducted.
Since this is the last cost a company incurs, and the final portion of the financial statement, the remaining amount is net earnings. This is the ultimate goal of the company, and investors.
Finding net margins is a result of taking net earnings and dividing over top of gross revenues. This yields a percentage for net margins.
Again, any company that performs well in this metric, all the way at the bottom of the financial statement, is the company that likely has the best opportunity to see its stock move higher.
In the example above for Apple, net earnings were $94,680,000. Dividing this by total revenue will yield 0.2588, or 25.9% net margins.