Why Rising Profits Isn’t Always a Great Thing

One of the very first things investors like to look at in a company is profit. If profits are increasing consistently every year, then it usually means the company is growing and doing well. But is it always the case where growing profits simply mean that a company is growing bigger and better? To gain a clearer picture of a company’s growth, you need to look at its net profit margin.

What is profit margin?

Net profit margin is simply the amount of profit its keeps for every dollar of revenue. The higher the margin, the more profitable a company is for every dollar it makes in revenue. Net profit margin is displayed as a percentage (%). For example, if a company makes $1 million in revenue and has expenses of $800,000, its profit is, therefore, $200,000 and its margin is 20%.

So what does this have to do with the growth of a company?

For a company to grow bigger, it almost always has to increase its expenses to grow its revenue. For example, for a company to increase its revenue, it needs to hire more salespeople to make more sales. In doing so, payroll is increased, more office space is needed to house everyone and a new Nespresso machine is required to keep everyone adequately drugged and happy throughout the day. In other words, costs go up. And if costs go up by too much, a company’s profit growth will be affected.

So the question is: Can the company maintain its net profit margin while growing its revenue and profits? There are 3 scenarios that could pan out:

1. Margin is maintained

It is an indication that a company is able to grow its revenue while keeping its costs in check. Revenue is up and profits are up in similar proportion. Overall this is a good sign that the company is growing well and steadily.

2. Margin increases

This means that a company has been able to grow its revenue and profits more efficiently while reducing its growth in costs. They may have streamlined their business operations or used technology to improve their productivity. Overall, increased net profit margins are a great sign. However, you should discount the increase if there are exceptional items such as a one-off profit made from the sale of an asset. These events don’t happen every year so the increase in profit margin is only temporary.

3. Margin decreases

This means a company needs to spend more in order to earn the same dollar. While overall revenue and profits may have gone up, this may not be a good sign. It could mean that the company has managed their expenses poorly or they have little or no control over external costs factors. For example, an airline company hit by rising fuel prices. If this issue is not addressed, you could very well see a dip in earnings in the near future.

The fifth perspective

While you always want to look for rising revenue and profit when analyzing a company, it is also vitally important to understand a company’s margins and cost structure. If the margins are continually being eroded (even though profits might be growing overall), the company’s growth could be hampered going forward, affecting your overall growth in your investment. So watch out for this!

Adam Wong is the editor-in-chief of The Fifth Person and author of the national bestseller Lucky Bastard! which made the Sunday Times Top 10 Bestseller’s List in 2009 and Value Investing Made Easy which made the Kinokuniya Business Bestseller’s List in 2013. In 2010, he appeared on U.S. national television on the morning show The Balancing Act. An avid investor himself, Adam shares his personal thoughts and opinions as he journals his investing journey online.

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