Use Margins to Pick Best
Sometimes picking the best stocks in an industry is as easy as looking
at gross or operating profit margins.
For instance, say that you were interested in automobile stocks when the
economy was still going strong in 2006. Using the annual results for
2005, here are the gross margins that you would have found for Ford,
General Motors, and Toyota: Ford 13%, General Motors 5%, Toyota 20%.
When analyzing profit margins, all you have to know is that higher is
better. Thus, the gross margin analysis would have singled out Toyota as
the strongest player. What’s nice about using gross or operating margins
is that you don’t need a calculator. Both Reuters (www.reuters.com)
and Smart Money (www.smartmoney.com)
do the math for you. All you have to do is look up the numbers.
Gross margin measures the profit a company makes on a product
considering only the cost of production. It doesn’t include overhead,
marketing, and R&D costs. A 25% margin means that the company is making
25 cents for every dollar of sales before deducting the other costs.
Gross margins tell you a lot about a company’s competitive position
within its industry. The firm with the highest gross margin has either
lower production costs, or it can sell its products at higher prices
because customers are willing to pay more for better-perceived quality.
For another example, consider microprocessor chipmakers Intel and
Advanced Micro Devices.
Looking at last year’s numbers, Intel’s gross margin was 56% compared to
Advanced Micro’s 40%. Consider the implications of that difference. In
2008, for every dollar of sales, Intel earned 56 cents that it could
apply to research and development, advertising, administrative costs, or
to add to profits. Advanced Micro, by contrast, had only 40 cents left
over for those items.
Gross margins work best for analyzing manufacturing companies. For
retail stores and other industries that sell directly to consumers,
you’ll get better results by comparing operating margins to pinpoint the
strongest players in an industry.
In addition to the cost of sales included in the gross margin
calculation, operating margins also consider overhead expenses, research
and development and most other costs of doing business except for
interest expenses and income taxes. Similar to gross margins, for
operating margins, higher is better.
If you had compared electronic retailers Best Buy and now bankrupt
Circuit City in the 1997 to 2000 timeframe, you would have found both
chains generating annual operating margins in the 3%
to 4% range. After that, however, Best Buy’s operating margin
moved up to the middle 5% range while Circuit
City’s margin dropped to 1%or so, and some
years even went negative.
Macy’s & Gottschalk’s
On a similar note, in recent years, department store chain Macy’s annual
operating margins typically ran from 8% to
9% until the economy tanked last year. By
contrast, Gottschalk’s, which recently filed for bankruptcy, could only
generate 2% or so margins.
You can find both the gross and operating margins in the Key Statistics
report on Smart Money and in the Ratios report on Reuters.
Every industry faces different competitive conditions. So, analyzing
gross and operating margins only works when comparing companies in the
same industry. Sure, there are plenty of other factors that affect share
prices, but doing those checks will help you pick better stocks.