Key Fundamentals: Sales, Margins, Return On Equity

Watch For Pitfalls In Sales Figures

Sometimes sales numbers mask problems at companies. Companies may rely on just a handful of customers, and losing any of them may mean big trouble. Other companies are overly reliant on overseas markets, putting them at risk of bad economies or political strife abroad. Also, fluctuations in foreign-exchange rates can seriously dilute sales figures. Some companies, such as pharmaceuticals, get the bulk of their sales from a few flagship products. If sales in these items falter, it could mean more trouble than if the overall sales drop. With retailers, additions of new stores increase the sales figures, even if sales at existing stores slow down. That's why retailers report total sales as well as same-store sales, to provide an apples-to-apples comparison. Another pitfall happens when companies include sales that haven't actually taken place. Orders that won't be shipped or paid until weeks or months later sometimes are added to the sales total to inflate results.

Profit Margins: Another Way To Assess Earnings Performance

Profit margins are the portion of a company's sales that end up as earnings. As an investor, look for companies that generate an increasing percentage of profit out of every dollar of sales. The larger the margin, the better a company is at managing and leveraging its business.

Studies of the greatest winning stocks revealed that most showed strong and even expanding profit margins before they made huge price moves. The best small and midcap stocks of the 1996-97 period had after-tax profit margins, on average, of 10% in the two quarters right before they made their main price gains. For big-capitalization stocks, the margins were 13%. Profit margins can be a major clue in finding the best stocks to buy, although the numbers vary widely among industries. For example, retailers tend to have smaller profit margins. Whatever the exact numbers, a company's margins should be among the best in its industry.

Let's take profit margins one step further. There are two types of profit margins. One is called the after-tax margin, and it calculates the percentage of earnings that come from sales after taxes have been paid. Let's take one company that earned $10 million from $100 million in sales. This gives it a profit margin of 10%. What if this company had to pay $2 million in taxes? What would that do to the margin? Well, deduct the $2 million tax payment from the $10 million in earnings and you've got $8 million in earnings. Divide that by the $100 million in sales, and the margin is now only 8%. The other type of margin is the pretax profit margin, and -- you guessed it -- it ignores the taxes a company pays. Analysts and investors scrutinize both numbers. Some prefer pretax margins because they show realistic profitability without the distortion of varying tax rates.

The rule of thumb for all companies except retailers: seek companies with annual pretax profit margins of at least 18%. After-tax margins should be at all-time highs for the company or within 10% of the high.

Of course, increasing profit margins alone don't make for a good investment. You need to keep an eye on all the key fundamentals, such as earnings growth. Rising profit margins mean little if sales are dropping, unless there's a change in strategy and the company drops inefficient product lines, for example. Also, if margins start trending lower, it could indicate the company is losing ground to competition.

One other note: increasing profit margins aren't the same thing as increasing earnings, as we've shown with the above examples. Suppose a company earns $10 million from $100 million in sales, resulting in a 10% profit margin. The next quarter it earns $10 million from just $80 million in sales, for a 13% margin. You see how a higher margin doesn't automatically mean bigger profits?