Introduction
One of the most important questions to ask yourself as an investor is: how profitable is this company?
As an investor, in order to find the right stock to invest in, you'll need to understand the trio of margins: gross profit margin, operating profit margin and net profit margin.
The Differences of Gross, Operating, and Net Profit Margin Explained
Essentially, there's two ways to look at profitability.
- How much does a company make on it's products or services? In this case Gross Margin is relevant.
- How much does a company make as a business after covering its costs? In this case Operating Margin & Net Profit Margin are relevant.
Gross Profit Margin Explained
In order to see how much a company makes on it products or services, you can look at its gross margin.
Gross margins explain what the company makes after covering the production costs. The production cost can vary business to business, but it's essentially the cost for a business to make its products. In the case of a milk business, this would be the cost to produce the milk, the carton to package it and its potential shipping cost.
A high gross margin means that the difference (or markup) between the sale and the cost for the business is high.
Higher gross margins means that there's more to earn per sale. So typically, if a company has a position as a market leader, it has the ability to sell its products for a higher gross margin. In this case it can be attractive an attractive business for investors.
How to Calculate Gross Profit Margins
The formula to calculate gross profit margin is:
Gross Profit Margins = (Revenue - Cost of Revenue) / Revenue * 100
In the last quarter of Nike's Income Statement, you can see the following:
- Total revenue was 13.388B.
- Cost of revenue was 7.4174B
- Gross Profit 5.971B
Based on these numbers you can calculate its gross profit margin as follows:
(13.388 - 7.4174 (= 5.971)) / 13.388 * 100 = 44.6%
Operating Profit Margin Explained
In contrast, operating profit margin provides a broader picture of the business.
This metric includes all operating expenses, for example:
- Research and development
- Marketing costs
- The cost of an office space
- The salaries of the employees.
As an investor, it's important to note that you need to look at its operating margin in the context of its industry. Some industries are very capital intensive (airlines, shipping companies) whereas others boast substantial gross margins (technology companies).
How to Calculate Operating Profit Margins
The formula to calculate operating profit margin is:
Operating Profit Margins = (Revenue - Total Expenses) / Revenue * 100
In the last quarter of Nike's Income Statement, you can see the following:
- Total revenue was 13.388B.
- Cost and expenses were 11.563B
- Operating Income was 1.825B
Based on these numbers you can calculate its operating profit margin as follows:
(13.388 - 11.563 (= 1.825)) / 13.388 * 100 = 13.7%
Net Profit Margin Explained
Lastly, net profit margin provides the most comprehensive view of them all. Beyond operations, this metric accounts for all expenses, painting the full picture of a company's profitability.
The difference between Operating Margin and Net Profit Margin
While operating margin includes all operational activities, net profit also includes non-operational activities of a business. What are non-operational activities of a business you might ask? You can best think of these as outside activities such as external investments or external costs. Non-operational costs might be taxes that a company occurs or interest payments to any debt that a company has. Outside of costs, a company might also earn through non-operating activities when a company decided to invest outside of its main activity.
Conclusion
As you can see each margin tells a unique story about a company's financial health.
If you want to see how well a company is doing in terms or profitability of its total business: Net Profit Margins are your guide.
For more granular understanding of the business there's Operating Margin.
And for understanding the margins of a business' products or services: Gross Profit Margins.
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