Investors take on risk whenever they buy shares of companies, which makes it very important to carefully select which stocks to buy. One factor that investors can consider is a company's profit margin: the percentage of its total revenues that represent profit. A good profit margin tells a prospective stock buyer several things about the potential investment.
Average and Strong Profit Margins
According to Bloomberg, the average profit margin for American corporations in early 2018 was about 11 percent. This represented strong profit margins from three decades of relative affluence and economic growth. In fact, that 11 percent represented the highest average profit margin since at least 1990. For most of the intervening years, average profit margins ran in the six-to-nine percent range.
Profit Margin Meaning
A profit margin that approaches or surpasses 10 percent reveals important information about a company's performance. Profit margins show how well a company can control its costs, especially relative to other companies in the same industry. A business that maintains a high profit margin shows that it can increase its prices to cover the rising cost of labor, raw materials and other operating expenses. High profit margins also indicate that businesses can reduce their prices and still remain profitable, allowing them to respond to competition or reduced buying power from their customers.
Profit margins also show trends over time, which is useful information for potential investors. A rising profit margin, for example, shows that a business is gaining more control over costs and finding success in its current strategy. A diminishing profit margin, even if it is at or above average, might indicate that a business will have trouble remaining profitable in the future. This downward trend makes a stock less appealing, and it probably will drive down share prices unless other factors support them.
Low Profit Margins
Stock in a business with a low profit margin is not necessarily a poor investment. Low profit margins can have many reasons, and other factors influence stock price as well. For example, if two competing companies in the same industry both have diminishing profit margins, the stock of the company with the margin that is shrinking most slowly might rise relative to its apparently weaker competitor.
The ability for a business to increase its stock price also depends on its strategic position and potential for growth. A new business might have a low profit margin because it is incurring startup costs each quarter, but once those costs are paid, the mature company could have a much higher profit margin, rewarding investors who bought shares when its margin was low.
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