Earnings growth is perhaps the most important metric investors will want to see when looking to buy a stock. Right alongside it? Profit margins.
Expressed as a percentage, a profit margin is simply the portion of revenue a company gets to keep after subtracting costs. A margin of 50% would mean the company generated 50 cents of profit for each dollar of revenue.
Margin alone, however, isn't especially informative. What investors will want to pay attention to are a company's margin trends and where its margin stands in relation to other companies in its sector.
Margin trends can tell you a lot about where a company is in its growth cycle. If a company is spending more money to generate profit, its margins will shrink. But that's not necessarily a bad thing, especially if the company is generating meaningful revenue.
Amazon.com lost money for years as it was building out its infrastructure. But Wall Street knew that investments and steady revenue from its flagship e-commerce business would eventually fuel profit growth down the line.
Conversely, if a company is growing more efficiently, its profit margin will expand as expenses fall relative to total revenue. So-called margin expansion — Wall Street parlance for increasing profitability — is thus a sign of a company whose stock could be primed for a move upward. Margins, in a sense, are a way to judge the quality of earnings.
Whatever the trend, it's crucial to compare a company's margin to industry peers. Margins above the industry average would show whether a company is a standout performer or just a typical player in its industry.
Keep in mind that average margins vary widely, depending on the industry. For example, research from New York University's Stern School of Business shows that semiconductor equipment, entertainment software and oil-and-gas industries generate pretax margins (excluding options compensation) well above 30%. Auto parts, regional banks and food wholesalers have margins below 7%.
Nvidia Stock And Profit Margins
Profit margins can be parsed several ways. One measure to pay attention to is the after-tax profit margin for each quarter. For any company you research, look for that margin to be at or close to its highest levels over the past several quarters. And ideally, margins should be among the best in the company's industry.
Investors also should check annual pretax margin. IBD research has found that the biggest stock-market winners often had an average annual pretax margin of at least 18% before they began major price moves.
Nvidia shares had traded between 40 and 50 in the second half of 2023. But the stock started rising to new highs in January of this year. Let's take a look at what was happening with its fundamentals: From the January 2023-ended quarter to the October 2023 period, earnings per share grew 488%, 574%, 153% and 101%, according to FactSet. Simultaneously, pretax margin went from 15.5% to 17.2%, 33.9% and 46.8%. Those numbers confirmed the company's earnings prowess.
Margins also confirm Nvidia as an industry leader: IBD's database shows Nvidia ranks in the top three in its industry in terms of pretax and after-tax profit margins. The stock ended November above 138 per share.
Unless you use tools provided by some financial websites, there's no easy way to research and compare margins other than checking financial reports for the company and its competitors. As a shortcut, Investor's Business Daily's SMR Rating for individual stocks helps investors quickly identify firms with strong sales, margins and return on equity. Stocks are rated on an A-E scale.
Profit Margins In Action
Even in small-margin industries, it pays to study each company vs. its rivals.
Among grocery store operators, one of the big leaders in the group is Sprouts Farmers Markets. No surprise it has the top margins in the sector, with annual pretax margin of 5.7% and quarterly after-tax margin of 4.7%.
Compare that to Albertsons Cos., one of the worst performers in the group, which has some of the lowest annual pretax margin and quarterly after-tax margin in the group at 2.7% and 1.6%, respectively. Through November, Sprouts had climbed 221% year to date and Albertson's was down nearly 14%.
Among discount retailers, TJX Cos. and Ross Stores have been top performers even with margins that may look lackluster. TJX's annual pretax margin in its latest fiscal year was 10.8%, while after-tax margin in its latest reported quarter was 9.2%. Ross Stores reported similar margins of 12.1% and 9.6%. Year to date, TJX was up 34% through November; Ross Stores was up less than 12%.
In the aerospace and defense group, Northrop Grumman has been a laggard. Its most recent annual pretax margin was 6.4%, while quarterly after-tax margin was 9.6%. Compare that to one of the strongest price performers in the group, Curtiss-Wright, which delivered an annual pretax margin of 16.5% and quarterly after-tax margin of 14.3%. In 2024, Curtiss-Wright has rallied almost 68%, while Northrop is up only 4.6%.
