Profit Margins: The 5th Element of The Buffett Way

By: Martin Sejas


Profit margin is the theme of this final article in the series about Value Investing which is a concept that is commonly underutilised in finance today. Nevertheless, profit margin is something that all investors tend to look at when decide which stocks to invest in. The reasons behind must be understood.

Before outlining the reasons behind focusing on profit margins when making investment decisions, I find it ideal to explain what "profit margin" actually means for those who are new amateur investors. Basically, profit margin is written as a percentage which refers to the proportion of net sales that becomes net income after all expenses are taken into account, which normally 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.

The above explanation clearly demonstrates how advantageous it can be to be aware of the profit margins of a company. Nevertheless, Warren Buffett has his own way of using profit margins which have brought him so much success over the years.

The Buffett methodology revolves around historical profit margins. That is, profit margins recorded over a number of years in the past. A good strategy is to go back at least 5 years and see how profit margins have evolved since. In total there are 3 types of profit margin patterns that an investor can observe and the reason why they should each be understood is explained below.

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 common pattern is that of an increasing profit margin over the time period chosen. This is obviously good news for any investor, but before making any decision to invest, it may be wise to go through other parts of the Buffett methodology explained in the 4 previous articles of this series.

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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About the author: Martin Sejas is the owner of Stocks-And-Commodities.com, an influential stocks trading website dedicated to finding the best and the newest strategies and techniques for stocks and commodities trading. Its goal is to become the 'one-stop shop' on the best stocks trading websites and programs on the World Wide Web.

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