Profit Margins: Keeping What You Earn
Revenue is vanity, profit is sanity. Margins tell you how much of each dollar actually becomes profit.
The Three Key Margins
1. Gross Margin
Formula: (Revenue - Cost of Goods Sold) ÷ Revenue
What it measures: Profit after direct costs (materials, manufacturing)
Example:
- Revenue: $100
- Cost of goods: $40
- Gross Profit: $60
- Gross Margin: 60%
2. Operating Margin
Formula: Operating Income ÷ Revenue
What it measures: Profit after operating expenses (salaries, rent, marketing)
Example:
- Revenue: $100
- Operating expenses: $30
- Operating Income: $30
- Operating Margin: 30%
3. Net Margin
Formula: Net Income ÷ Revenue
What it measures: Final profit after everything (taxes, interest, etc.)
Example:
- Revenue: $100
- All expenses + taxes: $80
- Net Income: $20
- Net Margin: 20%
The Waterfall
Think of revenue as water flowing into a series of pools:
- Gross Margin — First pool after paying for raw materials
- Operating Margin — Second pool after paying employees and rent
- Net Margin — Final pool after taxes and interest
At each stage, some water (money) leaks out. High-quality businesses retain more water at each stage.
What Margins Tell You
| Margin Type | Reveals |
|---|---|
| Gross | Pricing power, production efficiency |
| Operating | Operational efficiency, scale benefits |
| Net | Overall profitability, tax efficiency |
Key Takeaways
- Gross margin shows pricing power and direct costs
- Operating margin shows operational efficiency
- Net margin shows final profitability
- Higher margins generally indicate higher quality
Margins by Sector
| Sector | Gross Margin | Operating Margin | Net Margin |
|---|---|---|---|
| Software | 70-85% | 20-40% | 15-30% |
| Pharma | 60-80% | 20-35% | 15-25% |
| Consumer Brands | 40-60% | 15-25% | 10-20% |
| Retail | 25-40% | 5-10% | 2-5% |
| Grocery | 25-30% | 3-5% | 1-3% |
| Airlines | 30-40% | 5-15% | 2-8% |
Key insight: A 5% net margin is excellent for grocery but poor for software.
Margin Trends Matter
One year's margin isn't enough. Look for:
Expanding Margins
- Operating leverage kicking in
- Pricing power increasing
- Costs being controlled
- Bullish signal
Stable Margins ➡️
- Consistent business model
- Competitive position maintained
- Neutral signal
Contracting Margins 📉
- Competition increasing
- Costs rising
- Pricing power weakening
- Bearish signal
Operating Leverage
Companies with high fixed costs and low variable costs have "operating leverage." As revenue grows, margins expand because fixed costs are spread over more sales.
Example: Software companies have high operating leverage—each additional sale costs almost nothing to deliver.
Margin Quality Indicators
Signs of High-Quality Margins:
✅ Consistently above industry average ✅ Stable or expanding over time ✅ Supported by competitive advantages ✅ Not dependent on one-time items
Signs of Low-Quality Margins:
🚩 Below industry average 🚩 Declining trend 🚩 Volatile year-to-year 🚩 Boosted by cost-cutting (not sustainable)
Comparing Margins
When comparing companies:
- Same industry only — Margins vary wildly by sector
- Check trends — Direction matters as much as level
- Understand the model — High-volume/low-margin vs. low-volume/high-margin
- Consider scale — Larger companies often have margin advantages
Margin Traps
- Comparing margins across different industries
- Ignoring margin trends (direction matters)
- Assuming high margins will continue forever
- Not understanding why margins are high/low
How ShareValue.ai Uses Margins
Our Quality Score incorporates margins by:
- Comparing to sector peers — Is this company more profitable than competitors?
- Tracking trends — Are margins improving or declining?
- Weighting by sector — Margins matter more in some industries
- Combining with other metrics — Margins are one piece of the quality puzzle
Next up: Debt levels—the double-edged sword of corporate finance.