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Examining the Net Profit Ratio of Different Industries and its Stages

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.

net profit ratio

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.

How Expenses and Liabilities Can Affect Margins

A company with a high net profit ratio has lower expenses in relation to the money it brings in (revenue, aka sales), and so it will have “higher margins”. A company with a low net profit ratio has the opposite.

Another way to understand this relationship is by defining the idea of “capital intensive businesses”. The business models of various industries can widely differ based on a lot of different things.

Say you own an oil drilling business that requires very expensive machinery to drill the oil and create sales. Compared to the business owner with the software company, who can spend much less to update its software than you can to maintain your machinery, you will likely have much lower profit margins (net profit ratio). In the stock market, having those type of high maintenance expenses would define your business as very capital intensive.

There’s many implications to having a high capital intensive business, as well as the possibility of slower growth potential due to needing lots of capital, but we won’t go too into the weeds about that here.

So a business with a low net profit ratio can mean that they are very capital intensive, but that isn’t necessarily always the case. It can depend on the business cycle, the industry, and the age of the industry– which we will examine next.

How Industry Cycles Generally Behave

Just as the economy has natural life cycles of boom and bust, industries also have life cycles that generally define how they progress. You have the Growth Phase –> Maturity Phase –> Decline Phase.

In general, the margins of an industry in the growth stage are very high.

This tends to attract competition and can be characterized by huge sprints of growth with the companies involved. Innovation tends to be at the forefront of this growth, and a new company with the best innovation can see their profits skyrocket– which leads to competitors copying the innovation and eventually, slowing the earnings growth of all of the players.

As an industry matures, the growth of profits tends to slow, which tends to push down the net profit ratio. Businesses might need to spend more and more to keep up their levels of growth, as they can’t rely on the newness of innovation as much. This can make expenses pile up and again, push down margins.

One of the ways that businesses try to grow in a maturing industry where innovation drives less and less growth is by making mergers and acquisitions. If smart acquisitions are made, businesses can grow their top and bottom lines and even cut expenses by making “synergies”, combining the value that various business models already produce to save on costs.

For example, if a company has a global distribution chain in place with a product that ships by plane, they can add a second product and use that same distribution chain almost essentially for free. They can add a second product by buying a company that produces said product, and then cut the costs of the distribution of the acquired company by simply using their own.

What mergers and acquistions tend to do to a maturing industry is lower the number of competitors. The competitors that don’t have the capital resources to make these kinds of acquistions may start to lose market share and their ability to compete, and this can also lower the number of players in the market. The net profit ratio can ebb and flow during a time of industry consolidation and somewhat slowing growth, but the generally accepted idea is that the next industry period is characterized by complete maturation or saturation– less competitors and again, lower profit margins.

An industry could saturate the market, after all there are only so many people on Earth and only so much land, etc. It’s widely believed that at this point, net profit ratio is much lower than at its growth stage, which can make it a much less attractive business.

Now that you have a pretty detailed background on how the industry age can affect net profit margins and profitability in general, I want to highlight the exact extent that these characterizations really have on stocks– with real data.

Let’s see for ourselves whether these generalities actually hold true, by how much, and how they should influence our stock picking.

Q #1: Do Profit Margins Really Shrink with Time?

As I explained above, it makes sense that the net profit ratio should start to compress over time. After all, a company can only get so big, and big size can be expensive.

But by how much?

To answer this question, I took a look at a data set by Aswath Damodaran. The data includes over 100 industries and was updated on January 2018.

Knowing this fact, we have to be careful with our conclusions. Because this is looking at a simple point of time, there’s a chance this data is skewed based on the current economic and market cycle. It very well could fluctuate through the years.

I’m hoping that the sheer number of businesses and industries considered will mitigate much of this potential bias. I can also make an update, if you are reading this sometime in the future, leave a comment below if that’s something you’d like to see.

Remember that the number of businesses tends to shrink over time as an industry gets consolidated. So to measure the maturity of these industries, I imported the data into my own Google Sheet and sorted it by the “Number of firms” column. Again, not a perfect measure, but it should generally get the job done.

Next, I took the average net profit ratio (described as net margin in the dataset) of the top 47 industries and bottom 47 industries based on size. We will define the top 47 based on size as our “growth” group, and the bottom 47 industries based on size (lowest number of firms) as our “matured” group.

The final adjustment that needs to be made has to do with the industries with negative net profit ratios. Negative values will skew the average, so I replaced the negative numbers with zeroes so we get an accurate average net margin. I’ll display the resulting data here with conclusions below.

Industry Name Number of firms Gross Margin Net Margin
Banks (Regional) 612 99.77% 23.82%
Drugs (Biotechnology) 459 72.99% 12.57%
Oil/Gas (Production and Exploration) 311 53.64% 0.00%
Software (Internet) 305 66.93% 23.83%
Financial Svcs. (Non-bank & Insurance) 264 81.50% 26.46%
Software (System & Application) 255 66.61% 14.59%
Healthcare Products 251 57.45% 8.52%
R.E.I.T. 244 61.96% 24.44%
Drugs (Pharmaceutical) 185 70.96% 14.05%
Business & Consumer Services 169 32.25% 5.19%
Electronics (General) 167 29.41% 6.67%
Investments & Asset Management 165 69.81% 22.54%
Household Products 131 50.87% 13.90%
Oilfield Svcs/Equip. 130 13.05% 0.73%
Machinery 126 34.67% 8.27%
Electrical Equipment 118 32.85% 6.21%
Healthcare Support Services 115 14.34% 2.58%
Heathcare Information and Technology 112 51.59% 8.54%
Precious Metals 111 44.59% 3.55%
Computer Services 111 25.42% 5.93%
Retail (Special Lines) 106 26.91% 3.18%
Telecom. Equipment 104 52.90% 13.76%
Metals & Mining 102 30.49% 6.03%
Chemical (Specialty) 99 36.42% 7.53%
Retail (Distributors) 92 27.87% 3.93%
Entertainment 90 41.91% 11.50%
Environmental & Waste Services 87 32.86% 4.41%
Aerospace/Defense 87 20.63% 7.22%
Food Processing 87 29.05% 7.37%
Restaurant/Dining 81 29.81% 9.98%
Semiconductor 72 54.69% 18.10%
Recreation 70 38.60% 2.12%
Hotel/Gaming 70 54.39% 8.25%
Telecom. Services 66 55.77% 8.38%
Auto Parts 62 17.64% 5.32%
Retail (Online) 61 43.76% 3.72%
Information Services 61 50.84% 13.39%
Power 61 39.42% 13.93%
Real Estate (Operations & Services) 60 46.92% 5.18%
Computers/Peripherals 58 34.69% 14.34%
Apparel 51 49.73% 3.43%
Insurance (Prop/Cas.) 50 26.66% 5.17%
Engineering/Construction 49 11.15% 1.99%
Construction Supplies 49 21.66% 4.78%
Semiconductor Equip 45 43.72% 18.74%
Brokerage & Investment Banking 42 69.02% 15.01%
Publishing & Newspapers 41 39.29% 0.00%
Advertising 40 27.61% 5.45%
Building Materials 39 27.02% 6.30%
Chemical (Basic) 38 19.18% 5.77%
Steel 37 16.05% 3.51%
Hospitals/Healthcare Facilities 35 36.43% 0.61%
Beverage (Soft) 35 56.02% 10.86%
Education 34 41.67% 1.38%
Farming/Agriculture 34 11.02% 3.08%
Homebuilding 32 20.33% 5.98%
Furn/Home Furnishings 31 25.90% 5.89%
Trucking 30 20.36% 1.99%
Coal & Related Energy 30 23.18% 12.62%
Beverage (Alcoholic) 28 48.70% 21.18%
Broadcasting 27 52.64% 4.09%
Retail (Automotive) 25 21.69% 3.27%
Insurance (Life) 25 27.63% 4.85%
Packaging & Container 25 23.33% 5.25%
Electronics (Consumer & Office) 24 32.53% 0.00%
Office Equipment & Services 24 33.90% 2.25%
Diversified 24 20.62% 8.54%
Tobacco 24 58.77% 43.37%
Utility (Water) 23 54.32% 12.96%
Green & Renewable Energy 22 57.41% 1.27%
Paper/Forest Products 21 18.97% 2.26%
Insurance (General) 21 25.69% 2.41%
Real Estate (Development) 20 39.70% 13.45%
Telecom (Wireless) 18 56.55% 1.01%
Auto & Truck 18 12.22% 2.07%
Retail (General) 18 25.45% 2.32%
Transportation 18 21.04% 4.44%
Utility (General) 18 38.53% 9.48%
Air Transport 17 32.49% 7.03%
Oil/Gas Distribution 16 38.39% 2.04%
Food Wholesalers 15 16.96% 1.34%
Retail (Grocery and Food) 14 22.21% 1.62%
Cable TV 14 60.80% 7.88%
Software (Entertainment) 13 66.18% 15.97%
Shoe 11 43.73% 9.44%
Bank (Money Center) 11 100.00% 26.03%
Real Estate (General/Diversified) 10 55.30% 8.99%
Shipbuilding & Marine 9 23.78% 0.00%
Retail (Building Supply) 8 34.15% 7.00%
Transportation (Railroads) 8 47.25% 18.68%
Chemical (Diversified) 7 22.29% 5.58%
Oil/Gas (Integrated) 5 38.45% 5.64%
Rubber& Tires 4 24.18% 6.64%
Reinsurance 3 15.89% 5.26%

 

Perhaps unsurprisingly, the average net profit ratio for the Growth group 9.56%, while the average net profit ratio for the Matured group was 7.17%.

The matured industries did indeed face lower margins. However, what I found interesting was that this disparity was very small.

It seems to be widely believed that growth stocks can and should average 25% margins, compared to matured, blue chip stocks that should average approach margins of 1-2%.

I think that idea is pretty overblown, and that the idea that margins will compress by huge percentages over time due to market conditions just isn’t as impactful as generally believed. What’s more likely is that industries cycle between high and low profitability, and that net profit margins depend much more on that rather than industry age or size.

Q #2: Are the Variations in the Net Profit Ratio Predictable Based on the Business Model?

Next let’s tackle the idea that business models greatly affect the net profit ratio, and that as investors trying to pick stocks, we need to make MAJOR exceptions for a business based on how the industry generally tends to operate. The prevalent idea from most of Wall Street is that we should compare profit margins only by industry, so you compare competitors’ profit margins only inside the industry and not over the overall stock market.

To make an observation here, we will use the same net margin dataset but instead sort by Net Margin rather than by Number of firms. Here’s that data and conclusions below:

Industry Name Number of firms Gross Margin Net Margin
Tobacco 24 58.77% 43.37%
Financial Svcs. (Non-bank & Insurance) 264 81.50% 26.46%
Bank (Money Center) 11 100.00% 26.03%
R.E.I.T. 244 61.96% 24.44%
Software (Internet) 305 66.93% 23.83%
Banks (Regional) 612 99.77% 23.82%
Investments & Asset Management 165 69.81% 22.54%
Beverage (Alcoholic) 28 48.70% 21.18%
Semiconductor Equip 45 43.72% 18.74%
Transportation (Railroads) 8 47.25% 18.68%
Semiconductor 72 54.69% 18.10%
Software (Entertainment) 13 66.18% 15.97%
Brokerage & Investment Banking 42 69.02% 15.01%
Software (System & Application) 255 66.61% 14.59%
Computers/Peripherals 58 34.69% 14.34%
Drugs (Pharmaceutical) 185 70.96% 14.05%
Power 61 39.42% 13.93%
Household Products 131 50.87% 13.90%
Telecom. Equipment 104 52.90% 13.76%
Real Estate (Development) 20 39.70% 13.45%
Information Services 61 50.84% 13.39%
Utility (Water) 23 54.32% 12.96%
Coal & Related Energy 30 23.18% 12.62%
Drugs (Biotechnology) 459 72.99% 12.57%
Entertainment 90 41.91% 11.50%
Beverage (Soft) 35 56.02% 10.86%
Restaurant/Dining 81 29.81% 9.98%
Utility (General) 18 38.53% 9.48%
Shoe 11 43.73% 9.44%
Real Estate (General/Diversified) 10 55.30% 8.99%
Diversified 24 20.62% 8.54%
Heathcare Information and Technology 112 51.59% 8.54%
Healthcare Products 251 57.45% 8.52%
Telecom. Services 66 55.77% 8.38%
Machinery 126 34.67% 8.27%
Hotel/Gaming 70 54.39% 8.25%
Cable TV 14 60.80% 7.88%
Chemical (Specialty) 99 36.42% 7.53%
Food Processing 87 29.05% 7.37%
Aerospace/Defense 87 20.63% 7.22%
Air Transport 17 32.49% 7.03%
Retail (Building Supply) 8 34.15% 7.00%
Electronics (General) 167 29.41% 6.67%
Rubber& Tires 4 24.18% 6.64%
Building Materials 39 27.02% 6.30%
Electrical Equipment 118 32.85% 6.21%
Metals & Mining 102 30.49% 6.03%
Homebuilding 32 20.33% 5.98%
Computer Services 111 25.42% 5.93%
Furn/Home Furnishings 31 25.90% 5.89%
Chemical (Basic) 38 19.18% 5.77%
Oil/Gas (Integrated) 5 38.45% 5.64%
Chemical (Diversified) 7 22.29% 5.58%
Advertising 40 27.61% 5.45%
Auto Parts 62 17.64% 5.32%
Reinsurance 3 15.89% 5.26%
Packaging & Container 25 23.33% 5.25%
Business & Consumer Services 169 32.25% 5.19%
Real Estate (Operations & Services) 60 46.92% 5.18%
Insurance (Prop/Cas.) 50 26.66% 5.17%
Insurance (Life) 25 27.63% 4.85%
Construction Supplies 49 21.66% 4.78%
Transportation 18 21.04% 4.44%
Environmental & Waste Services 87 32.86% 4.41%
Broadcasting 27 52.64% 4.09%
Retail (Distributors) 92 27.87% 3.93%
Retail (Online) 61 43.76% 3.72%
Precious Metals 111 44.59% 3.55%
Steel 37 16.05% 3.51%
Apparel 51 49.73% 3.43%
Retail (Automotive) 25 21.69% 3.27%
Retail (Special Lines) 106 26.91% 3.18%
Farming/Agriculture 34 11.02% 3.08%
Healthcare Support Services 115 14.34% 2.58%
Insurance (General) 21 25.69% 2.41%
Retail (General) 18 25.45% 2.32%
Paper/Forest Products 21 18.97% 2.26%
Office Equipment & Services 24 33.90% 2.25%
Recreation 70 38.60% 2.12%
Auto & Truck 18 12.22% 2.07%
Oil/Gas Distribution 16 38.39% 2.04%
Trucking 30 20.36% 1.99%
Engineering/Construction 49 11.15% 1.99%
Retail (Grocery and Food) 14 22.21% 1.62%
Education 34 41.67% 1.38%
Food Wholesalers 15 16.96% 1.34%
Green & Renewable Energy 22 57.41% 1.27%
Telecom (Wireless) 18 56.55% 1.01%
Oilfield Svcs/Equip. 130 13.05% 0.73%
Hospitals/Healthcare Facilities 35 36.43% 0.61%
Publishing & Newspapers 41 39.29% -1.18%
Shipbuilding & Marine 9 23.78% -1.80%
Oil/Gas (Production and Exploration) 311 53.64% -6.62%
Electronics (Consumer & Office) 24 32.53% -10.63%

 

The big takeaway here is this: the stereotypes about different business models didn’t hold as true as generally believed.

People think that tech stocks should average 40% margins since the cost of computer based technology is so low, while big grocery chains can get away with sub 3% margins because they are simply very capital intensive and always will be.

While the difference in margins is again, likely there because different business models are unique, I don’t believe it to be as extreme as “conventional” wisdom states.

The average profit margin across all industries was about 8%. This is really close to the conclusions made by Mark J. Perry, who wrote an article dictating that the average profit margin was around 7% while the general public thought it was around 35%.

In fact, only one business had margins above 30%, and that was tobacco– an undisputed mature industry. It’s likely that they had a big year of profits rather than 43% profitability being a defining feature.

Looking at the data as it is organized, it does appear that software companies dominate the top half of the spreadsheet while retail companies are generally near the bottom. However, the question remains: is that due to the characteristics of the business or because of the life of the industry (hundreds of years versus maybe 2 decades)? Is it a combination of both?

I’m thinking it has to do more with the second part rather than the first part, though I may be wrong. Look at insurance, for example. It varies from 25% to 5% to 3%– and how different can the business models of insurance be?

There are just lots of general questions left here.

Why is metals and mining, an obviously highly capital intensive industry, not in the 1-3% range but rather sitting at 6%?

Why is telecom equipment at 13% while telecom is at 1%? Computers are at 14% while computer services are at 5.9%? Shouldn’t services be cheaper than manufacturing? A ctrl+f search of services shows a high of 13% and low of 2%. A “ctrl+f” search of “products” shows a similar range, high of 13% and low of 2%.

The bottom line is, there doesn’t seem to be much rhyme or reason to why certain industries have higher net profit ratios than others based on a cursory look. What we DID see, however, was a pretty apparent correlation between the number of firms and net profit margins– implying that industries DO have their margins squeezed by maturation, but perhaps by not that much as it may seem.

Conclusion: Net Profit Ratio and Stock Valuations

Knowing these key takeaways about net profit ratio provide a somewhat sombering conclusion. That is, there’s no magic ratio about margins that tell us whether to buy or sell.

A business can create great profits and stock performance on either low margins or high margins. We can truly understand this if we understand how stocks generally trade.

The stocks with low margins tend to also trade at low P/S ratios. That means that these businesses have high amounts of sales, so the “disadvantage” of lower net profit ratios is mitigated by the business’s sheer size of capital coming in.

On the flip side, stocks with high margins tend to trade at high P/S ratios. This can indicate less overall sales and a possibility of a competitor coming in with little capital and destroying the profit margins of an industry.

As you can see, there’s no free lunch. An industry’s greatest advantage can also become its greatest weakness, and so is the same with individual stocks.

But the takeaway is actually great news for the average investor.

If you, as an investor, can find stocks that are trading with great P/E ratios AND great P/S ratios, you can capture the benefits of each characteristic that comes with these varying net profit ratios. Because the P/E ratio is calculated with Net Income and the P/S ratio is calculated with sales, you can automatically account for net profit ratio by using a combination of P/E and P/S.

The thing I said above can make investing in high profit margin stocks difficult. They tend to be much more expensive from a P/S standpoint. Knowing this, you might think you have to buy into more maturing industries to pay fair prices but get lower net profit ratio stocks.

But you also understand the data we’ve disccused in this post. What we’ve learned is that the impact of industry age isn’t all that much, and that margins can swing based on the profitability of the year.

So, you can be patient, and adjust your valuations based on various profit margins in different industries. You can pivot and adjust based on the stock.

Say you have a business with a fantastic P/E ratio. You’re getting lots of profits if you buy this stock. That’s an obvious huge advantage. You probably have lots more wiggle room with the P/S ratio, and can afford to “spend liberally” on a stock with a less than ideal P/S ratio but high margins. Those high margins can mean high rates of reinvested capital and future growth.

On the flip side, say you have a business with a super low P/S ratio, but the margins are terrible. Well, you could relax the P/E ratio knowing that even though the net profit margin is low, we’re getting a business with very strong revenues that likely has a stout position in its industry and ability to potentially grow quite quickly with just a small focus on improving its margins and cutting costs.

There’s no one magic financial or accounting ratio that will give you consistently high stock market returns, net profit margin included.

But that’s okay, because when we start to combine several ratios together, we start to get a much better picture of the health of a business and its opportunities for future growth– both in the business itself and in the stock price.

Focusing on that, rather than the wild assumptions and rationalizations that many investors make to pay super high premiums on the stocks they want to buy, can really help us buy low and sell high for great stock market gains.