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The fifth and final part of this series deals with the profit margin, which is traditionally an undervalued concept in finance today. Profit margin is something that many shareholders are concerned about when going through the books of their company and they always urge directors to improve profit margins. But why do they do this?

However, before I can explain the reasons, it’s important to define the term profit margin given that many people are still bewildered by its meaning. Simply put, it is the percentage of net sales that becomes net income after subtracting expenses which includes tax.

Therefore, a high profit margin means that the company is controlling its costs very well, which is what investors all look for. On the other hand, a low profit margin indicates a low margin of safety meaning that a decline in sales could quickly erase profits and result in a net loss.

Obviously, profit margins are a good indicator as to whether a company is really worth investing in. Despite that, most investors don’t use effectively use profit margins to maximise their chances of success just like the master Warren Buffett.

The master’s technique is basically focused on looking at the history of profit margins of a company, whether it be 5, 10 or 20 years. A recommended time frame would be 5 years which should give you a good indication of profit margins have changed since. There are 3 patterns that should be observed, all of which are detailed in the following paragraphs.

A typical pattern observed is a stable profit margin over the time period chosen for the analysis. This can be both good and bad news for the investor. It is positive news for the investor if this is high because it means that any increases in expenses during that time have been absorbed and controlled well. It is negative news for the investor if this is low because it implies that the company has not been able to keep expenses under control over that period of time.

Another typical pattern observed is one where the profit margin has steadily increased during your elected analysis time frame. This implies that the company has managed to control expenses so well to the point that they have been falling with each sale. Nevertheless, you should still look at the other component of the Warren Buffett methodology, indicated in my previous articles before making any decision.

A third typical pattern observed is one where the profit margin has steadily decreased during your elected analysis time frame. This implies that the company has been unsuccessful in controlling rising expenses over time and is largely negative news for investors. That said, it would still be wise to look at the other 4 component of the Buffett methodology before making a final definitive decision.

Overall, Buffett’s successfully methodology is based on 5 principles, which are all fully outlined in my articles for your own benefit. Any investor which is not aware of his strategies would be foolish not to study them. That said, you should not limit yourself to Buffett’s way of investing. There are many great and useful strategies out there, which I will be writing about in the next couple of days. Stay tuned!

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