Analyzing Margins

You can use three different margins to gauge profitability: gross margin, operating margin, and overall profit (net income) margin. All three are computed by dividing profits by total sales:

margin = profit/total sales

Margins can be computed for any period (e.g., days, weeks, months), but for stock analysis, the only periods used are the last quarter (three months), the last four reported quarters (TTM), or a fiscal year. The only difference between the three types of margins is the profit figure that is compared to sales.

Gross Margin

Theoretically, gross income is the profit made on a product considering only the costs of materials and labor to produce the product. Gross profit is sales less the cost of sales:

gross profit = total sales – cost of sales

Gross margin is the gross profit divided by total sales:

gross margin = gross profit/sales

When Home Depot sells a hammer, its gross profit is the difference between the sales price and the price that Home Depot paid for the item. The costs to put the hammer on the shelves, advertise it, ring up the sale and put the hammer in a bag are not considered in the gross profit calculation. The product costs are labeled cost of goods sold, or cost of sales on the company’s operating statement.

The hammer example holds true for many firms. However, many others, Microsoft for instance, add depreciation and amortization (D&A) charges to the product cost. In these instances, the cost of sales listed on the company’s operating statement filed with the SEC and on operating statements compiled by Multex, includes these embedded D&A charges.

But Media General Financial Services deducts the embedded D&A charges from the cost of sales and lists them on a separate line on the income statement. Media General determines the embedded charges by comparing the D&A listed on the cash flow statement to charges listed on the income statement.

Bottom line: MSN Money, Hoover’s, and other sites displaying Media General compiled data will show lower costs of sales, and hence, higher gross margins, than listed on the reporting firm’s own financial statements and on sites using Multex supplied data. You will get different answers calculating gross margins for the same companies on sites using Media General data than you’d get calculating gross margins on sites using Multex data.

Media General’s approach makes sense in theory. But it makes a variety of other changes to a company’s financial statements besides for the D&A adjustment, including adjustments to the reported sales total. Media General doesn’t provide any explanation of its changes, making it virtually impossible to reconcile its statements to the company’s SEC filings.

Consequently, I generally use Multex financial statements unless I’m comparing gross margins of companies with dissimilar D&A accounting practices that would affect the calculations.

Operating Margin

Operating expenses include costs of goods sold, plus sales, general and administrative (SG&A) expenses, research and development, depreciation and amortization (if not in cost of sales), and most other costs of doing business, except interest expenses and taxes. Operating income is sales less operating expenses:

operating income = total sales – operating expenses

Because it doesn't account for interest expenses and income taxes, operating income is also called EBIT, an acronym for earnings before interest and taxes. Operating margin is:

operating margin = operating income/total sales

Since depreciation and amortization are included in operating expenses, if not already included in cost of sales, the differences between the Multex and Media General totals mostly disappear by the time you calculate operating margin.

Net Profit Margin

The net profit margin calculation takes all other expenses not included in the operating margin calculation into account, namely interest expenses and income taxes.

Income before taxes is the operating income (EBIT) less interest expenses:

income before taxes = operating income – interest expense

Net income is operating income less interest expenses and income taxes.

net income = operating income – interest expense – income taxes

The net profit margin, is net income divided by total sales:

net profit margin = net income/total sales

The net profit margin is often simply called the profit margin. Net income is the bottom line, and EPS is the net income divided by the number of outstanding shares.