Profit Margin: Definition, Types, Uses in Business and Investing

What Is Profit Margin?

Profit margin is a common measure of the degree to which a company or a particular business activity makes money. Expressed as a percentage, it represents the portion of a company’s sales revenue that it gets to keep as a profit, after subtracting all of its costs. For example, if a company reports that it achieved a 35% profit margin during the last quarter, it means that it netted $0.35 from each dollar of sales generated.

How Profit Margin Works

Businesses and individuals across the globe perform economic activities with the aim of making a profit. Numbers like $X million in gross sales or $Y million in earnings are useful but don't address a business's profitability and comparative performance. Several different quantitative measures are used to compute the gains (or losses) a business generates, which makes it easier to assess the performance of a business over different time periods or compare it against competitors. These measures are called profit margins.

While privately owned businesses, like local shops, may compute profit margins at their own desired frequency (like weekly or monthly), large businesses, such as publicly traded companies, are required to report them in accordance with the standard reporting timeframes (typically quarterly and/or annually). Businesses that are running on borrowed money may be required to compute and report their profit margins to lenders (like a bank) on a monthly basis.

Types of Profit Margins

While net profit margin is the most familiar and commonly used measure, there are actually four levels or types of profit margins, based on four kinds of profits:

• Gross profit margin
• Operating profit margin
• Pre-tax profit margin
• Net profit margin

These profits are reflected on a company's income statement in the following sequence:

1. A company reports its sales revenue, then accounts for the direct costs of producing its products or services. What's left is the gross profit.
2. Then it accounts for indirect costs, like those associated with maintaining company headquarters, advertising, and R&D. What's left is the operating profit.
3. Next it factors in interest on debt and adds or subtracts any unusual charges or inflows unrelated to the company's main business. The result is its pre-tax profit.
4. Finally it accounts for taxes, leaving the net profit, also known as net income, which is the very bottom line.

Here are the mathematical formulas for calculating the four types of profit margins.

Uses of Profit Margin in Business and Investing

From a billion-dollar corporation to an average Joe’s sidewalk hot dog stand, profit margin is widely used by businesses across the globe. It is also used to indicate the profitability potential of larger sectors and of overall national or regional markets. It is common to see headlines like "ABC Research warns on declining profit margins of American auto sector," or "European corporate profit margins are breaking out."

In essence, the profit margin has become the globally adopted standard measure of the profit-generating capacity of a business and considered a top-level indicator of its potential. It is one of the first few key figures to be quoted in the quarterly results reports that companies issue.

Business owners, company management, and external consultants use it internally for addressing operational issues and to study seasonal patterns and corporate performance during different time frames. A zero or negative profit margin translates to a business that's either struggling to manage its expenses or failing to achieve good sales. Drilling it down further helps to identify the leaking areas—like high unsold inventory, excess or underutilized employees and resources, or high rentals—and then to devise appropriate action plans.

Enterprises operating multiple business divisions, product lines, stores, or geographically spread-out facilities may use profit margin for assessing the performance of each unit and compare them against one another.

Profit margin often comes into play when a company seeks funding. Smaller businesses, like a local retail store, may need to provide it for seeking (or restructuring) a loan from banks or other lenders.

Large corporations issuing debt to raise money are required to reveal their intended use of the capital, which can provide insights to investors about the profit margin that might be achieved either by cost cutting, increasing sales, or a combination of the two. The number has become an integral part of equity valuations in the primary market for initial public offerings (IPOs).

Finally, profit margins are a significant consideration for investors. Investors looking at funding a particular startup may want to assess the profit margin of the potential product/service being developed. While comparing two or more ventures to identify the better one, investors often hone in on their respective profit margins.

Comparing Profit Margins

Profit margin has its limitations, however, in terms of comparing companies. Businesses with low-profit margins, like retail and transportation, will usually have high turnaround and revenue, which can mean overall high profits despite the relatively low profit margin figure. High-end luxury goods, by comparison, may have low sales volume, but high profits per unit sold.

Below is a comparison of the profit margins of four long-running and successful companies in the technology and retail space:

Technology companies like Microsoft and Alphabet have high double-digit quarterly profit margins compared to the single-digit margins achieved by Walmart and Target. However, that does not mean Walmart and Target did not generate profits or were less successful businesses compared to Microsoft and Alphabet.

A look at stock returns between 2006 and 2012 shows similar performances across the four stocks, although Microsoft and Alphabet's profit margins were way ahead of Walmart and Target's during that period. Since they belong to different sectors, a blind comparison based solely on profit margins would be inappropriate. Profit margin comparisons between Microsoft and Alphabet, and between Walmart and Target are more appropriate.

Examples of High Profit Margin Industries

Producers of luxury goods and high-end accessories can have a high profit potential despite low sales volume, compared with the makers of lower-end goods. A very costly item, like a high-end car, may not even be manufactured until the customer has ordered it, making it a low-expense process for the maker, without much operational overhead.

Software or gaming companies may make a substantial investment initially in developing a new software product or video game but cash in big later by selling millions of copies with very little additional expense. Similarly, patent-secured businesses like pharmaceutical companies may incur high research costs initially, but reap high profit margins when they bring a new drug to market.

Examples of Low Profit Margin Industries

Operation-intensive businesses like transportation that may have to deal with fluctuating fuel prices, drivers’ perks and retention, and vehicle maintenance usually have lower profit margins.

Agriculture-based ventures usually have low profit margins owing to weather uncertainty, high inventory, operational overheads, need for farming and storage space, and resource-intensive activities.

Automobiles also have low profit margins, as profits and sales are limited by intense competition, uncertain consumer demand, and high operational expenses involved in developing dealership networks and logistics.

The Bottom Line

There are many different metrics that analysts and investors can use to help them determine whether a company is financially sound. One of these is the profit margin, which measures the company's profit as a percentage of its sales. In simple terms, a company's profit margin is the total number of cents per dollar a company receives from a sale that it can keep as a profit.

The most common and widely used type of profit margin is net profit margin, which accounts for all of a company's costs, both direct and indirect.