FOOL SCHOOL
Net Margin

November 16, 2001

In the earlier articles in this mini-series, we looked at gross and operating margins. Here we look at net margin, the final piece of the jigsaw. This is calculated as:

   Net Profit
  ------------
     Sales

Where net profit is the profit attributable to shareholders. This is almost the last number you will see in a typical profit and loss statement. Almost, but not quite.

                              'Year 2'       'Year 1'
Sales                         100,000         90,000
Cost of Sales                 (60,000)       (55,000)
                              -------        ------- 
Gross Profit                   40,000         35,000
Operating Expenses            (10,000)        (9,000)
                              -------        -------
Operating Profit               30,000         26,000
Net Interest Payable           (5,000)        (4,000)
                              -------        -------
Pre Tax Profit                 25,000         22,000
Tax on Profit                  (8,250)        (5,500)
                              -------        -------
Net Profit                     16,750         16,500
Dividends                     (10,000)       (10,000)
                              -------        -------
Retained Profit                 6,750          6,500

The net profit margin in 'Year 1' was 18.33% (16,500 / 90,000) and fell to 16.75% in 'Year 2'. As you can see, it is calculated on a company's net profit rather than retained profit. Calling net profit "profit attributable to shareholders" makes more sense. From its net profit, a company can choose to pay a dividend to shareholders, like most UK companies, or choose to keep all the profits in the business, as a lot of the younger US companies do. Microsoft, for example, for all its millions of dollars of profits and cash, doesn't pay a dividend.

Recapping using the above example:

                       'Year 2'  'Year 1'

Gross Margin             40.0%     38.9%
Operating Margin         30.0%     28.9%
Net Margin               16.8%     18.3%

With both gross and operating margins on the increase, 'Year 2' is looking rosy. But wait, look at the net profit. It has only increased by £250 from 'Year 1'. The company was forced to maintain its dividend at the 'Year 1' level, even though they thought they'd had a bumper year. The thorn in their side was the increased tax rate. It jumped from 25% in 'Year 1' to 33% in 'Year 2', causing the net profit to remain almost static.

Gross and operating margins are important to investors, as they give us an insight into the progress of the company and its control on costs and selling prices. However, net profit and therefore net margin are what really count. Quoted companies are (or at least ought to be) in the business of creating shareholder value. The only way to do that is to increase the profit attributable to shareholders, or net profit. That is why earnings per share (EPS) is calculated on that figure, and why it is considered so important to investors. Companies are ultimately valued on a multiple of net profits, or earnings. If you wanted to buy this company, you would consider offering a price that is, say, 10 times their profits. Or 20 times, if you thought its chosen market was about to take off. That is why the net margin figure is so important.

> Gross Margin | Operating Margin

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