Profit margins
Gross, operating and net margin, and how to compare them fairly: against the company’s own history and its direct competitors, not across industries.
Three margins
Divide each profit line by revenue and you get a margin. Gross margin shows how profitable the product is. Operating margin shows how profitable the whole business is, and net margin is what finally reaches shareholders.
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Margins make companies of very different sizes comparable. A $10 billion company earning $1 billion and a $100 million company earning $10 million both have a 10% net margin.
Each gap between margins tells a story. A big drop from gross to operating margin means heavy spending on sales, research or admin. A big drop from operating to net margin usually means hefty interest or taxes.
Compare like with like
A 3% operating margin is excellent for a supermarket and a disaster for a software company. Always judge a margin against the company’s own history and its direct competitors.
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Industries have typical margin ranges because of how they compete. Grocers sell near-identical products on thin margins and make it up on volume. Software has high gross margins because each extra copy costs almost nothing to deliver.
Even within an industry, business models differ. A luxury carmaker and a mass-market one both build cars, but their margins are worlds apart.
Watch the direction
A margin that rises year after year usually means pricing power or growing efficiency. A margin that keeps falling means costs are growing faster than sales, and that deserves a question.
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Operating leverage explains why margins swing. When most costs are fixed, extra sales fall almost straight to profit and margins widen fast. It works in reverse too: when sales drop, margins collapse.
Look for the cause, not just the trend. A margin can rise because a company cut research or marketing it will need later. That flatters this year and hurts the next five.
Key terms
- Gross / operating / net margin
- Gross profit, operating income or net income ÷ revenue.
- Peer comparison
- Judge ratios against the same company’s history and direct competitors, never across industries.
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