There’s a lot of widely held beliefs about net profit ratio and how it can vary based on industry, whether the industry is mature or in its growth stage, and how certain business models function. This leads to lots of justifications and poorly made assumptions.
This blog post will outline, with data, why much of it is overblown, and what the REAL implications of margins and profit ratios are.
Before we start, I want to warn you that this is a very advanced topic requiring a decent mastery of the financial statements of a stock. If you are still a beginner to investing, I highly recommend going through the guides first and then coming back.
To truly understand the net profit ratio, we must define it first.
Then we’ll look at live data spanning almost 100 industries to examine the net profit ratio and how it relates to particular industries.
Finally, we’ll make some key conclusions on what the data is truly telling us and how we can use it to make smart investing decisions on individual stocks.
Defining the Net Profit Ratio/ Net Profit Margins
The net profit ratio is actually a very simple calculation. You simply take the following 2 figures from the income statement of a company’s 10-k annual report:
Net Profit Ratio = Net Income / Sales
It’s often expressed as a percentage, so to do that, simply multiply the calculation above by 100.
The net profit ratio is a profitability ratio designed to tell you how efficient a company is at taking its revenues and converting them to profits (or earnings).
As you’ll soon discover as you wade into the world of fundamental analysis of stocks, one of the difficult things about accounting and stock market financial metrics is that there can be multiple terms that define the same thing.
So for example, profits can also be described as Net Income, Earnings, Net Earnings, Net Profit, or even “the Bottom Line”. As it relates to this blog post, the net profit ratio can also be described as Net Profit Margin, Profit Margin, or Net Margin… depending on who you’re talking to it can be described in several ways.
Alright, back to the definition of net profit ratio. It is a measure of efficiency. In other words, how much do expenses eat up potential profits. [click to continue…]