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Profit Margin - How It Works and How Investors Can Use It

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When it comes to the stock market, sometimes you might hear the term "profit margin" mentioned. It refers to a fundamental analysis metric that is popular among active stock traders.

This article will explain what profit margin is and how investors might be able to benefit from using it.

 

What Exactly Is Profit Margin?

Profit margin is a term that refers to a key measure of profitability for companies.

It essentially tells you how much profit a company makes for every dollar of sales it generates.

Here is the formula for calculating profit margin:

Profit Margin = Net Income / Revenues

Net Income is the profit of the company after all costs and expenses have been subtracted from revenues. It is also sometimes referred to as "Net Earnings" or "Net Profit".

Revenues refer to the total sales of the company before costs and expenses are deducted. This is sometimes also referred to as Gross Income.

The profit margin value will be displayed as a percentage.

There is another metric called gross profit margin that takes the gross profit of a company and divides it by the company's total revenues. The gross profit is equal to the company's revenues minus its cost of goods sold, which, in other words, is the company's profit before accounting for overhead costs.

 

Why Does Profit Margin Matter in the Stock Market?

Profits are a cornerstone of any company's financial health and are often referred to as the "bottom line" since they can be found at the bottom of a company's income statement.

Many people feel that a company's value lies in its ability to generate profits, since earnings represent the net incremental economic benefit a company is creating.

Profit margin is therefore important to investors since a company's profit margin is a key aspect to its profitability, and therefore a key aspect to its value.

Companies with increasing profit margins might merit consideration by investors. If profit margins are increasing, it can be seen as a sign of strength for the company.

Profit margins can vary a lot by industry. It might be helpful for an investor to compare profit margins between companies in the same field when trying to do analysis for potential investments. Comparing the profit margin of an AI software company to a farm equipment manufacturer, for example, may not be effective since they're in completely different industries and have different business models.

 

How Do You Find Stocks With Increasing Profit Margins?

You can find them by using our Increasing Profit Margins scanner. It's a free tool we offer here at Stock Market Guides. It uses our proprietary scanning technology to find stocks that have increasing profit margins.

Here's how the scanner results look:

 

That tool ensures that you don't have to waste time flipping through stock profiles manually to find stocks with increasing profit margins.

 

Example of a Profit Margin Investing Strategy

For this example of a Profit Margin investing strategy, we're going to look for stocks with increasing profit margins and plan to hold them for up to a year.

 

 

Our research suggests this simple strategy might have a track record of success.

 

Entry for the Profit Margin Investing Strategy

The entry for this Profit Margin strategy will be as follows:

The entry criterion for our Profit Margin investing strategy is very simple.

Exit for the Profit Margin Investing Strategy

There are a lot of possibilities here for the exit.

For any given investing strategy, it can be helpful to define two different criteria for the exit: a profit target and a time limit.

Not everyone sets exit criteria for a long-term investment, and that's totally fine. Ultimately, you are in charge of your investments, and you can manage them any way you want. But for the purposes of this investing strategy example, we will define them:

 

1. Profit Target

We will set a profit target that would reflect a 30% gain if the position were to be sold at that price.

In other words, we will take the price we paid for the stock at entry, multiply it by 1.3 (which effectively adds 30%), and use that to set up a sell limit order as a profit target.

If the sell limit order gets filled before the time limit is reached, then our investment is complete, and we will have realized a 30% return on investment.

2. Time Limit

We will set the time limit as one year. If the stock has not hit the profit target within one year of the date of stock purchase, then we can close the trade manually at the stock's prevailing price.

 

How Well Do Profit Margin Investments Actually Work?

The idea of a profit margin investing strategy sounds nice to many people because it offers a clear, easy-to-understand way to find an investment idea.

But does it actually work? Can traders indeed generate profits from buying stocks with increasing profit margins?

That's exactly what our company can help answer for you, since our scanner technology has allowed us to do our own research on that precise question.

The answer is that investments based on increasing profit margins are not always profitable, but for certain stocks they might indeed have a track record of success according to our backtest research.

Here is some data that shows how a proprietary profit margin investment strategy we created has performed historically according to backtests:

 

 

Anyone who signs up for our stock scanner service will be able to see stocks that qualify for that trading strategy in real time.

 

Learning More About Profit Margins

You can contact us any time if you would like to ask any questions about profit margins or anything else related to the stock market.