3 ways to determine a company’s profit margin before investing

1. Gross profit margin

The gross profit margin is what the company makes after the cost of goods sold is accounted for. The formula for determining gross profit margin is to subtract the cost of goods sold from the sales, and then divide that number by total sales.

If a company has made $10 million in sales, and the cost of goods is $3 million, the profit margin is:

$10 million - $3 million = $7 million. $7 million / $10 million = 0.70, or 70%.

The higher the gross profit margin, the more liquidity a company has. Gross profit margin can help you understand how well the company uses raw materials and labor in production, and how much cash a company has. A company with a declining profit margin has less cash, and less liquidity.

You want to make sure the gross profit margin of a company is in line with the rest of the industry.

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2. Operating profit margin

Rather than just looking at a comparison of sales and the cost of goods, the operating profit margin is a measure of how well a company's operations lead to profits. The formula for operating profit margin divides a company's earnings before interest and taxes by its sales.

In our example above, a company might have $10 million in sales, but its earnings might be a little different. Perhaps the earnings before taxes and interest are only $4 million.

The operating profit margin takes into account the administration and other costs as well as the cost of goods sold. So, to figure the operating profit margin, you would divide $4 million by $10 million to get 0.40 or 40%. A higher operating profit margin indicates that the company is efficient at managing costs, and that can be a positive sign.

3. Net profit margin

When figuring the net profit margin, you divide the net income by the sales of the company. Net income involves the amount of money coming in from all sources, and the costs that offset it. In our example, the company might only have $4.2 million in net income. As a result, the net profit margin would be 42%.

The net profit margin is representative of how managers and operations are doing. You should compare the numbers with other companies in the industry, since it's unfair to compare companies in different industries too closely.

Profit margins for some industries are naturally smaller than those of other industries. You want to compare apples to apples when deciding which companies to invest in.

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Bottom line

A company's profit margin provides clues about its efficiency, and how it uses its cash and other resources. You'll want to look at a number of factors, from human capital to revenue to the balance sheet, when deciding on a company, but profit margin is a good place to gain insight as well.