The goal of every business is to make money. How much money they make boils down to the profit margin they can achieve from the sale of goods or services. Specifically, companies and their investors need to focus on net margin: the percentage of revenue left after deducting operating expenses, preferred stock dividends, interest and tax from total revenue. This figure represents the final profit generated as a percentage of revenue from sales.

The higher a company’s net margin, the more revenue it generates from sales. Companies with good margin reach profitability faster than those with poor margin, and, all forces equal, have a higher profit ceiling. Here’s what every investor should know about net margin and how it represents business operations.

How to Calculate Net Margin

Margin is the earning power that accompanies sales. As such, it’s calculated by looking at the difference between profit and revenue. Calculating net margin is simple:

Net Margin = Net Profit / Net Revenue

Keep in mind that this equation is a “net” equation—meaning it factors in costs associated with sales. This includes cost of goods sold (COGS), operating expenses, interest and taxes. All this information is readily available on a company’s income statement. And, since net margin is best expressed as a percentage, multiply the above equation by 100 to convert it.

Margins as a Financial Metric

Another way of looking at net margin is as the amount of profit the business generates from every dollar earned. It’s an efficiency metric. If Company A generates a 30% margin (\$.30 on the dollar) and Company B generates a 15% margin (\$0.15 on the dollar), it’s evident to investors which company is more efficient. Company B needs to sell twice as much as Company A to generate the same amount of profit.

Net margin is also indicative of a company’s management. A business with climbing overhead and COGS suggests that the business isn’t adapting. Leadership needs to focus on decreasing costs to maintain a healthier margin. Again, it’s possible to measure this relative to the performance of competitors.

It’s most important to consider net margin in the context of total revenue. A company that generates \$1 billion in revenue with a net margin of 5% is still more profitable than a company that generates \$10 million with a 20% margin.

Net Margin Varies Widely Across Sectors

A company’s net margin depends heavily on the industry it’s in and the product or service powering its business model. As a result, companies tend to have very different income statements and cash flow representations.

• Service businesses tend to be higher-margin than product businesses. Some of the highest-margin businesses today are X-as-a-Service (XaaS) businesses, such as Software-as-a-Service (SaaS) or Payments-as-a-Service (PaaS).
• The tech sector is home to businesses with the highest net margin, since the solutions they provide are digital in nature. Technology allows these companies to keep COGS extremely low to maximize net margin.
• Sectors with heavy operational expenses and high overhead tend to face fluctuating costs. As a result, they have variable and often lower net margin. This can include industrials, agriculture, telecom and energy sectors.

This isn’t to say that there aren’t outliers. For example, luxury goods are consumer discretionary items that come with a hefty margin in a sector that’s traditionally low-margin. Likewise, growth-hacking tech companies may have little-to-no net margin for years as they focus on market penetration.

An Example

ABC Company has a net profit of \$10 million for the fiscal period, on revenues of \$2.5 million. The company’s net margin is 25%. To determine if this is healthy, investors would look at the corresponding margins of ABC Company’s closest competitors. If DEF Company has a 22% margin and GHI Company has an 18% margin, investors can feel confident that ABC Company is outperforming its peers from a sales efficiency standpoint.

Keep in mind that net margin can change with every financial reporting period. Healthy companies will keep a consistent margin; however, this is difficult for some companies depending on the industry. Established companies that have already maximized their margins may choose to focus on sales growth instead.

How to Improve Net Margin

Improving margins is a function of reducing costs—namely operating expenses and COGS. The less it costs to produce a good or deliver a service, the better the gross margin. The lower a company can keep its operating costs, the better the net margin. In either case, it’s in the best interest of companies to find efficiencies that enable it to retain more of the revenues it generates from sales.

Companies with savvy leadership will seek to identify extraneous costs on the income statement. By reducing or eliminating these costs—or by introducing new efficiencies—business leaders can bolster the company’s net margin and improve its path to profitability. And, of course, it’s always possible to raise prices to boost margin.

Higher Margins Take the Pressure Off Sales

We’ve all heard the adage “work smarter, not harder.” For many companies, the equivalent is increasing net margin, instead of simply focusing on selling. While more sales are always a good thing, there’s better profit opportunities in high-margin sales. For many companies, the prospect of selling 10 Widgets at a 50% margin beats selling 100 Widgets at a 5% margin.

And this can play a major role in a stock’s ability to rise over time. To learn more, sign up for the Profit Trends e-letter below!

Investors evaluating a company’s cash flows and incomes should pay attention to net margin. It’s an important metric in determining how efficient a company is—and how contingent on sales volume its profitability is. There’s nothing wrong with lots of sales—just make sure they’re backed by a healthy net margin.