“If you do good valuation work, the market will eventually agree with you.”
There are many methods for determining a company’s profitability. The net profit ratio is crucial since it measures how much money a business keeps after all costs are covered.
Net income equals a company’s earnings, which Wall Street and analysts love. Companies report their earnings quarterly, and the market puts a lot of emphasis on them, so we have many ways to use net income to give us plenty of information.
Joel Greenblatt created a simple way to measure the kind of return you can get from a stock using earnings. You get the expected return if you reverse the price-to-earnings or P/E ratio.
In today’s markets, finding companies generating profits is the golden rule; to find those companies, we need to understand and find ways to measure them. Enter the net profit ratio.
In today’s post, we will learn:
- What is the Net Profit Ratio?
- How Do We Calculate the Net Profit Ratio?
- How To Interpret the Net Profit Ratio
- Limitations of the Net Profit Ratio
- Real-World Examples of Net Profit Ratios
- What is a Good Net Profit Ratio?
Let’s dive in and learn more about the net profit ratio.
What is the Net Profit Ratio?
The net profit margin, also known as the net margin, calculates the amount of net income or profit as a proportion of revenue. It is the proportion of a company’s or business segment’s net profits to revenues.
Although companies can show it in decimals, most express the profit ratio as a percentage. A company’s net profit margin shows how much of every dollar revenue it receives converts into profit.
One of the most crucial measures of a company’s financial health is its net profit margin. A business can determine whether its existing procedures are effective and they can estimate earnings based on revenues by monitoring growth and reductions in their net profit margin.
It is easy to compare the profitability of two or more firms regardless of size because companies represent net profits as a percentage rather than a monetary value.
The net profit ratio includes all factors of a company’s operations:
- Cost of goods sold (COGS)
- Operating expenses, i.e., R&D, and SG&A
- Interest expenses (debt obligations)
- Investment Income
- Many more
Investors can determine whether Visa is making enough profit from sales and if management keeps operational costs and overhead costs under control.
For instance, Microsoft may experience rising sales, but the company’s net profit ratio would fall if expenses rise quicker than sales. Investors prefer to observe a history of expanding margins, which indicates that the net profit margin is escalating with time.
Most publicly traded companies publish their net profit ratios in their quarterly and annual reports since share price growth correlates with profit growth. Companies that can increase their net margins over time see share price growth.
How Do We Calculate the Net Profit Ratio?
We have two ways to calculate the net profit ratio. The first works down the income statement to arrive at our number. The second starts at the bottom and uses the net income to determine our ratio.
We’ll show you both, and you can choose the best.
Net Profit Ratio = R – COGS – OPEX – I – Taxes / R * 100
- R = Revenues
- COGS = Costs of goods sold
- OPEX = Operating and other expenses
- I = Interest expenses
- T = Taxes
Here are the steps:
- From the income statement, subtract the cost of goods sold(COGS), operating expenses (OPEX), other expenses, interest expenses, and taxes.
- Divide the net income (the result of our math) by the revenue (top line)
- Convert to a ratio by multiplying by 100
- Voila! We have a net profit ratio
The second process is far easier to manage. We take the net income (earnings) from the income statement’s bottom line and divide the number by the revenue or top line from the income statement. And then, we multiply the result by 100 to arrive at our ratio.
Net Profit Ratio = Net Income / Revenue * 100
How To Interpret the Net Profit Ratio
A company with a large net profit ratio can manage its costs and offer products or services for a price much higher than its costs. Some causes for a high net profit ratio include the following:
- Low costs or expenses
- Efficient management
- Strong pricing power
For example, many companies continue to struggle with bloat. In the tech arena, Google has continued to hire, even as sales slow. This has caused their profit margins to fall, leading to a falling stock price.
Others, such as Costco, manage their costs well and can maintain a level net profit ratio in all weather.
These examples help illustrate strong management teams able to manage their costs.
A low net profit ratio indicates a company using poor cost structures and pricing strategies. We can find low ratios from these causes:
- High costs (operating or costs of goods sold)
- Weak pricing power
- Inefficient management
Many companies discuss pricing power during their presentations, but during rising inflation or interest rate periods, you can see who has it.
For example, Apple continues to have the ability to raise prices on their iPhones, and people will pay. Likewise, with Coke, they raise the price of a Coke Zero a few cents, and it doesn’t impact demand.
But others, such as Costco, manage costs differently. They use relationships with suppliers to negotiate better pricing, which they pass on to the customer. For example, the famous hot dog deal never rises in price, in part because it is a loss leader; the hot dog helps drive traffic even if it loses Costco money. But they make up for it with higher margins on other items or by raising subscription fees.
Investors should use information like the net profit ratio as a starting point. It can serve as a comparison factor, for example, comparing Visa to Mastercard.
However, we should investigate further what drives the profitability for each company, good or bad.
Revenue reporting and costs included are different for the net profit ratio and gross profit margin.
Gross profit margin calculates the percentage by which total revenue exceeds the total cost of goods. It does this by dividing the total revenue and cost of goods by total revenue. The gross profit ratio accounts for the revenue left over after subtracting expenses for a product’s raw ingredients, manufacture, and distribution.
The net profit ratio considers the cost of producing a product and additional costs, such as staff salary, taxes, debt, and office costs.
Limitations of the Net Profit Ratio
Even though the net profit margin is a valuable indicator, it has significant drawbacks. It is a poor yardstick, for instance, for comparing businesses in various industries.
For example, some industries carry double-digit net profit ratios as the norm, whereas others with low single-digit remain the norm. The disparity makes it difficult to measure outside of industries. For example, comparing the net profit ratio of Costco to Visa is a poor comparison. But if you compare Costco to Walmart, you will find a more favorable comparison.
The net profit margin also sees some unusual changes from one-time events. These one-time events can lead to wild swings in net profit ratios over different periods.
Sales of assets may increase revenue, increasing the net margin. We can also see one-time costs having a large impact on a company’s profitability.
To use the net profit ratio as a comparison, we need to understand the different line items and their potential impacts on net profits on a period-by-period basis.
The net profit ratio remains one of the many metrics investors can use to analyze an investment and to verify the worthiness of a company.
Using the net profit ratio and other profitability ratios such as gross profits, operating profits, and free cash flow ratios is a great practice.
Real-World Examples of Net Profit Ratios
Below is the quarterly income statement for Microsoft, as reported on October 24, 2022:
- Total revenue or revenue for the quarter equals $50,122 million
- Net income equals $17,556 million
- We can calculate Microsoft’s net profit ratio by dividing its net income of $17,556 million by the total revenue of $50,122 million. Total revenues equal Microsoft’s revenue from products and services, which the company breaks out individually.
- Microsoft’s net profit ratio equals 35% ($17,555 ÷ $50,122 x 100).
Microsoft’s net profit margin tells us that for every dollar of revenue Microsoft generates, they keep $0.35 as profit.
Next, we will look at the net profit ratio of Costco. Below is the annual report (10-K) dated October 4, 2022:
- Costco’s net sales equal $226,954 million
- Their net income equals $5,844 million
- We can calculate Costco’s net profit ratio by dividing the net income ($5,844 million) by the net sales ($226,954 million). Costco divides revenue between net sales (products) and membership fees. They do this to help investors understand the business model and what drives the revenues.
- Costco’s net profit ratio equals 2.57% ($5,844 ÷ $226,954 x 100).
A great practice would be to look at a larger framework to see how Costco has performed long-term.
Net profit ratio
So we can see as the company has grown revenues, the net profit ratio has grown as well. If you wanted to see long-term trends, you could look farther out, say ten years.
For example, we can see from my favorite financial website, Stratosphere.io, that Costco has ranged from a low of 1.8% net profit margin to a high of 2.6% today. Over the last ten years, the company has averaged 2.2%.
Now, we can see Costco generates $0.02 for each dollar it creates, which might seem low. But for a low-cost provider, those kinds of numbers are the norm.
For example, Walmart has generated net profit ratios between 1.3% and 3.6% over the last ten years, with a ten-year average of 2.72%.
Remember, when comparing companies, we must look at businesses across the same industry. For example, comparing the net profit ratio for Wells Fargo to Visa will not produce good results, even though they operate in the financial sector, their business models remain vastly different.
What is a Good Net Profit Ratio?
That represents a great question, and like much in investing, it depends.
Services industries frequently have high-profit margins since they require fewer resources for production than an assembly line.
Similarly, software or gaming companies may make an initial investment while creating a specific software or game and profit greatly later by selling millions of copies with minimal outlays.
We can typically find lower profit margins in industries like transportation, which have higher operation intensity, which may have to cope with driver incentives, varying fuel prices, and retention, along with vehicle upkeep.
Automobiles also have low-profit margins because of the erratic customer demand, fierce competition, and expensive operational costs associated with building dealership networks and logistics, all of which limit profits and sales.
Even while different industries’ average net margins fluctuate significantly, organizations can generally acquire a competitive edge by boosting sales or cutting costs (or both).
However, increasing sales frequently gives need to bigger costs, resulting in higher costs.
Cutting expenses too much could have unfavorable effects, such as losing competent staff, switching to defective materials, or suffering other quality losses.
Expanding is the greatest course of action for many companies to reduce production costs without reducing quality. Economies of scale refer to the idea that bigger companies typically have higher profits.
To dive deeper into the question of a good net profit ratio, check out Andrew’s epic blog post, which contains answers to this question, along with data concerning the average net margin by S&P 500 industries.
The net profit ratio measures the profits Microsoft generates as a percentage of its revenues. We can use the net profit ratio to make data-based decisions about how well Microsoft uses its revenue.
As we have seen, each industry carries different profit margins. We must look at all sides when evaluating the net profit ratios. For example, a company with high costs of goods sold, like Cisco, will carry different ratios than Adobe.
The profitability of different industries will dictate how good or bad a ratio is. For example, Costco’s ratio of 2.6% might seem low, but compared to Walmart’s, it seems decent.
A better idea is to consider the business and how they generate revenue and compare it to the same industry.
We will wrap up our discussion for today on the net profit ratio.
Thank you for reading today’s post, and if I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,