An Introduction to Margin Analysis

Learning and perfecting strategies using margin analysis to invest in companies is complex yet rewarding. It is complex because not only must future economic trends be forecasted, but also once we have narrowed down the over 200 industries we then have to select the best stocks in those industries. Needless to say, this can be difficult, and understanding company financial statements is crucial. Interpreting the elaborate nature of these statements is perhaps the most important skill to have when evaluating stocks.

Learning and Understanding Financial Ratios

An easy way to begin understanding these statements is by learning the financial ratios and what they mean. Because there are many different ratios, they are broken down into various classes. Of the most widely used are profitability ratios. Profitability ratios measure a firm’s profitability, and are defined in terms of profit margin. For example, a firm’s net profit margin is the percentage of sales revenue the firm is left with after all expense and tax items are subtracted. Other profitability ratios include gross profit margin, operating margin, pretax margin, return on assets (ROE) and return on equity (ROE).

Interpreting and Using the Appropriate Ratios

Although going into detail about the nature of each ratio is beyond the scope of this article, it is generally better to have high margin ratios. In addition, when comparing two companies in the same industry, one ratio may give a more realistic comparison then another. Different accounting methods between firms can lead to misleading comparisons. For example, if a firm uses a different depreciation method then its competitor and this results in less reported net income, operating and net margins will be lower even though depreciation is a non-cash expense and does not effect the actual cash position of either firm. In this case, it could be more appropriate to compare the companies using gross profit margins, which excludes depreciation entirely.

ROE, ROA & ROC

Other profitability ratios measure returns against sources of capital invested in the firm. Common stock, preferred stock, and debt are the three sources of financing a company has access to. When profitability is measured in these terms, it becomes easier to see how efficiently each dollar of capital is being utilized. If these ratios are too low, it can mean a lack of efficiency in the use of funds provided to the company.

Retained Earnings

Understanding the firm growth helps to put in perspective the nature of equity itself. Part of a company’s net income is paid out to stockholders in the form of dividends (assuming the company pays dividends), and the remainder is what is called the firm’s retained earnings. When a firm has positive retained earnings at the end of an accounting period, the firm essentially went up in value by this amount and this should be reflected in the intrinsic value of the stock over time. Retained earnings is the best way for a firm to finance its operations and growth because there are no costs associated with its use, as opposed to interest charges related to debt and flotation costs related to new equity issues. 

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