Earning Online from Panama

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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.

As a consequence, if the profit margin is high, then costs are being kept under control which is a big positive for all keen investors. A problem arises if the profit margin is low which effectively means that an increase in costs could place the company in danger of seeing its profits turn into losses.

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.

The first type of pattern is a consistent profit margin. This basically means that in the last 5 years (or whatever number of years you choose to use) the profit margin has remained relatively stable. This is good news if the profit margin is high means that management has successfully been able to control any growth in expenses. However, it is bad news for any investor if this is low.

The second type of pattern is an increasing profit margin. This basically means that in your chosen period, the profit margin has steadily increased. This is great news for a budding investor, however, before choosing to invest in such a company, it’s recommended that you completely understand the other components of Buffett’s methodology before making a decision which are explained in my previous articles.

The third type of pattern is a decreasing profit margin. This basically means that in your chosen period, the profit margins have steadily decreased. This is certainly not good news for any investor because it means that management has not been able to control increasing costs over time. However, as I said before, any company should not be discarded without analysing the company using other components of Buffett’s methodology.

In conclusion, the methodology used successfully by Buffett is something that all investors should study, all of which are outlined in this article and the preceding articles. One would be crazy to not learn something from the richest man in the world. However, there are many other strategies out there which have been successful. Watch this space for many more great articles on stock trading strategies.