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Phil Fisher laid out fifteen points to look for in a common stock; three of them are directly related to profit margins. Calculated as net income divided by revenue, the profit margin is a quick way to determine which companies in an industry are most efficient (i) relative to the competition, and (ii) as a whole.

Does the company have a worthwhile profit margin?

To hammer the importance of this point home, you need not look further than traditional auto manufacturers.

Does the company have a worthwhile profit margin?

Auto manufacturers have historically low profit margins. MSN Money reports a 5-year industry average of just 3.4% for auto manufacturers versus 11.5% for the S&P 500. That is, for every dollar of sales at the auto manufacturer, just $0.03 ends up in net income. The rest is spent on costs of goods sold, operational expenses, etc.

Take, for example, General Motors (NYSE:GM). In its fiscal year ended December 31, 2007, General Motors reported $178.2 billion of automotive sales. To make the vehicles sold, GM reported "Automotive Cost of Sales" of $166.3 billion. Simple math would tell you that GM generated about $11.9 billion in revenue, after taking into account the cost of the materials to make the vehicles.

Here's the problem: In the three years leading up to the end of last year, GM had to spend an average of $13.7 billion on "Selling, General and Administrative" expenses — the costs to keep the lights on, to keep the salespeople motivated, to advertise, etc. $11.9 billion in, $13.7 billion out. Starting to see the problem?

When Margins are Slim

If your company doesn't have a "worthwhile" profit margin, it has a problem: When tough times surface (as they always do from time to time), weak margin companies will probably start burning cash rather than generating it. When things begin to turn around, your company's ability to generate cash will be delayed relative to its high profit margin competitors.

As your company begins to use cash rather than generate it, your ownership is in jeopardy. I'm not just talking about negative free cash flow; your company will have to sell assets, fire people, take on debt, and/or sell more stock. The result: Less sales as capacity to fill orders is diminished, lower profit margins and excess cash as interest expenses increase, and dilution of your ownership resulting in less value going forward.

Check out GM's balance sheet on Morningstar, and specifically look at the changes to shareholder equity. Here's a company that has spent the last ten years trying to keeps its head above water, struggling to find a balance between too big to be profitable and too small to maintain unit volume. When margins are too thin, the slightest breeze can knock your business around.

The Owner's Margin

Profit margins are important when looking at the industry and at historical figures for a company; the Owner's Margin looks forward.

Calculated as owner earnings (or free cash flow) divided by total revenues, the Owner's Margin can help you judge whether or not your business will be able to sustain prolonged periods of slowed sales or unusually high expenses.

In the case of General Motors, sales slipped and any excess cash they might have been able to eek out when times were good is now a pipe dream. Let's turn our attention to Pfizer.

Generating about $10.6 billion in owner earnings last year on sales of $48.4 billion, Pfizer's Owner's Margin is 22%. That is, for every dollar of sales that Pfizer recorded, it generated about $0.22 in excess cash. Think of it this way: If sales at Pfizer sank 20%, or $9.7 billion, to $38.7 billion, Pfizer would still be able to crank out more than $900 million in owner earnings without firing a single person, selling a single asset, or assuming a dime of additional debt (if it's business as usual).

A 20% hit to sales, and the company is still generating excess cash without making a single adjustment to its business? Now that's a worthwhile margin.

Of course, some adjustments would likely be made. At that level, Pfizer would definitely have to kill its $8 billion annual dividend payments (unless management wanted to foolishly assume $8 billion a year in debt to keep the dividend). Furthermore, Pfizer would likely cut staff and take other measures to return to a more worthwhile margin. Still, the company has the operational capacity to sustain a very serious hit to sales without sustaining a commensurate hit to operations or its balance sheet.

When Times Get Tough

Going back to troubled companies. If you are attributing GM's tough times to tighter consumer spending and higher gas prices, let's move out of the beaten down auto sector and move to another business — Blockbuster.

For its fiscal year ended December 31, 2006, Blockbuster reported total revenues of $5.5 billion. It generated just $183 million of owner earnings — an Owner's Margin of 3.3%. For the record, 2006 was a "business as usual" year for BBI.

Here's where it gets hairy: To generate cash and actually have any sort of value for investors, Blockbuster needs to keep sales extremely high, to keep expenses extremely low, and to operate at perfect efficiency. Any slight change can have a dramatic effect on the business.

Well, it got hairy for Blockbuster. Revenues and most expenses in 2007 were largely unchanged. However, Blockbuster's costs of sales increased by about 8%, from $2.5 billion to $2.7 billion. Owner's Margin of 3.3%; cost of sales increase of 8%. Doesn't look good for this fragile business.

Sure enough, Blockbuster's operations swung from generating owner earnings of about $183 million to requiring an additional $114 million after all expenses were paid. Its Owner's Margin dropped to a negative 2%. For every dollar of sales Blockbuster generated, it had to cough up $1.02 to keep the doors open.

In the highly competitive world of movie rentals (think Netflix, Wal-Mart, Apple TV, Comcast On Demand, etc.), a 3% Owner's Margin is definitely not worthwhile. And Blockbuster shareholders have suffered because of it.

What Is "Worthwhile"?

The term "worthwhile" is relative, and depends on your estimation of how bad things can get at your company. If you are expecting a 50% hit to Pfizer's total sales or a doubling of expenses at some point in the future, a 22% Owner's Margin is definitely not worthwhile. If, however, in the ordinary course of business and economic cycles, you would not be surprised by 10% swings in sales, a 13% or 15% Owner's Margin may very well be worthwhile.

As with everything in investing, look for a margin of safety. The higher the Owner's Margin, the better.

 

Source: Phil Fisher on Profit Margins