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FA Corner: True Profit Margins Explained

I came accross this article from fWallstreet which explains what is true profit margins. To cut the wrong story short, what is reflected in the balance sheet is vastly different from what an investor needs to make a comparison of 2 companies. This is the same for ROE, for PE, for PTB as well.

On the heels of yesterday’s article, I received an e-mail from a friend this afternoon asking me about my thoughts on inventory turns and profit margins. To paraphrase: The math doesn’t work right, as the inventory turns don’t affect the profit margins each year.

I didn’t do a good job of explaining it properly; so, let’s look at the “true” profit margin of a company.

The Low Cost Business

We all know that it’s better to have a low-cost business than a high-cost business. Companies with relatively small capital expenditures and fat profit margins should be chosen over those with high capital expenditures and thin margins, assuming all other things are equal.

If you can find good companies that generate tons of cash on a relatively small amount of invested capital, and you can buy those companies at a discount to their intrinsic value, you’ll probably find that your long-term investment results are quite satisfactory.

Profit Margin on One Inventory Turn

So…we turn to two businesses, each of which has a thin profit margin, to see how inventory turns can give us some insight into the economics of the company. Let’s first look at the economics of the business from a single sale perspective to show that they’re the same:

(Note: The number of “inventory turns” refers to the number of times a company must replenish its inventory throughout the year. If Walgreens orders one case of Coca-Cola each month, and sells one case each month, it will have “turned” its Coca-Cola inventory twelve times that year.)

Company A Company B
Revenue $ 100 $ 100
Cost of goods sold 98 98
Other expenses and taxes
Net income / Cash flow $ 2 $ 2
Profit margin 2% 2%

In this case, both businesses earned $2 on $100 of revenue. Their profit margins were 2% ($2 divided by $100). Fortunately, they lived in the land of Tina’s Family Therapy; so, no taxes or any other costs.

Both companies invested $98 in inventory (cost of goods sold), sold it for $100, and made a $2 profit. Simple enough.

Conventional wisdom would say that both businesses should be avoided. We’re supposed to look for businesses with wonderful economics, and a 2% profit margin is anything but “wonderful.” Then again, we’re all about being non-conventional around here.

Profit Margin on Multiple Inventory Turns

Same companies, but factoring one year of inventory turns into the mix:

[Read More at fWallStreet here >>]


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