Should You Invest in Businesses With Thin Profit Margins?
Profit margins are one of the most critical measures of a company’s financial health.
While they don’t show the full picture of potential earnings, net profit margins reveal how risky those earnings are.
Consequently, they are an indicator of whether the company is a good investment.
Varying Profit Margins
Simply put, the net profit margin is the percentage of a company’s sales that turns into profit.
It’s easily calculated by dividing net profit by total revenue and then dividing by a hundred.
To understand the meaning of the resulting figure you have to compare it to other companies.
The bigger the net profit margin, the more secure the business is likely to be.
Profit margins vary hugely by sector, so it’s essential to consider the sorts of comparisons that you’re making.
For example, supermarkets have notoriously thin profit margins.
The pressure of competition, high overheads, and the need to keep unprofitable stores open for the sake of purchasing power.
All these factors add up to keep profit margins in the low single digits.
Those with the highest profit margins, such as accountancy and real estate firms, can have margins of 17-18%.
If you’ve decided to invest in a particular sector because of other features, then it’s important to compare like with like on profit margins.
This allows you to judge how a company compares with its competitors.
On the other hand, if your options are wide open, you may want to steer away from sectors with low margins.
Vulnerability
Why are low-profit margins so bad?
The most general answer is that they leave a company vulnerable.
The profit is calculated from revenue less expenses. If it’s a slim percentage, then there’s not much margin for safety.
Any change in either revenue or expenses can wipe out a company’s whole profitability.
This means that if there’s an increase in costs, then the company is immediately going to run into problems.
Unless is can increase its prices, that cost is going to eat away profits, and if higher prices were possible, then the company would probably have them already.
Having thin margins also removes some of the tools that let companies cope with change.
If the gap between income and revenue is low, then it may be impossible to lower selling prices, for fear of losing all profit. That makes it harder to compete with other businesses.
The company will also have less purchasing power and less money to reinvest, as a portion of available funds has to be kept aside to deal with any shift in expenses or revenues.
A Bad Sign
As well as being bad in itself, a slim profit margin can be a sign of broader problems for a company.
Profit margins can be damaged by both internal and external factors.
External factors, such as shifts in the market or natural disasters, tend to hit all the companies in a sector and a region.
They might cut way profit margins, but by comparison with its competitors, a well-run company will still look relatively good.
Internal factors such as poor management or not investing in staff will disadvantage a company compared with its competitors.
A lower profit margin compared with the rest of the sector can be a symptom of this, indicating that the company is in trouble in other ways.
Good management balances revenue and expenses to stay in profit.
If a company’s managers aren’t achieving that central goal, then something is almost undoubtedly amiss.
Why Companies With Thin Profit Margins Often Make Bad Investments
Does this mean you should never invest in companies with thin profit margins? To a certain extent, this is a matter of investment strategy.
If you’re willing to take more significant risks for bigger rewards, then a company with thin profit margins but otherwise suitable measures may be worth considering.
On the other hand, if you’re looking for security over profitability, then thin profit margins should be a red flag for any investment, and possibly for entire sectors.
There are plenty of options out there, and you can afford to miss out on some of them. Whatever your strategy, profit margins should always be a consideration.
If you’re faced with two companies, otherwise equal, and one has better profit margins than the other, you can feel confident that the more profitable company is the better bet.
It’s probably better managed and certainly less financially vulnerable.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
