If a company sells a widget for 50 cents and the widget costs a buck to make, the company probably won't be in business for very long.
But if the widget sells for a buck and it costs 50 cents to make, well, that's a different story. Welcome to the world of profit margins, a closely watched fundamental metric on Wall Street.
The financial literature shows a variety of definitions for . IBD focuses on a company's pretax and after-tax profit margins on a quarterly and annual basis. The math isn't complicated. It's income divided by sales. It answers the question: For every dollar in sales, how much does the company actually keep in earnings? Profit margin of 30% means a company keeps 30 cents for each dollar of sales.
You can find a firm's annual pretax margin in IBD Stock Checkup at Investors.com. Another way to home in on firms with solid profit margin is with IBD's SMR Rating. It looks at a company's sales, margin and return on equity. Stocks are rated on an A-to-E scale with A being the best. Focus on those with an A or B. Some turnaround companies may show a worse grade.
Return on equity (ROE) is another important metric to follow because similar to profit margin, it helps separate well-managed firms from poorly managed ones.
You should generally target firms with annual ROE of at least 17%. But IBD research has found that in certain cases, a great stock might not meet the 17% ROE minimum yet still become a great market winner due to other strong fundamentals, including high pretax margin.
Ocwen Financial (OCN) is a good example. ROE in 2012 was 12.2% but annual pretax margin hit a multi-year high of 30.5%. There's no specific threshold to look for when assessing profit margin; just make sure it's at or near peak levels (see accompanying table).
Remember that profit margin varies by industry. Tech companies like Intel (INTC) and Apple (AAPL) are known for fat margins. In its latest reported quarter, Apple's after-tax margin was 21.9%. Pretty good on the surface but big profit margin isn't an automatic buy signal, especially in a case like Apple where margins have been compressing vs. year-ago levels in recent quarters.
Profit margin at retailers tend to be much lower. Annual pretax margin at discount retailer TJX Companies (TJX) has been accelerating since 2009. In fiscal 2013, margin hit 11.9%, nearly double what it was in 2008.
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