The Chicks' 12 Steps to Picking a Stock

STEP 7  Net Margins

Note: This article focuses on Step 7 of the Chicks' Dozen. For articles focusing on other Steps, see the links listed at the bottom of the page.

Here I am at the Lone Star Ranch in the province of Alberta writing today’s article on Net Margins. I am a chaperone for my daughter’s eighth-grade field trip. (I should really be supervising the girls in the cabin right now, but instead I’m sitting in the car right outside the door. You can only take so much "boy talk". Please don’t tell.) Hmm... so how can I relate Net Margins to a ranch in Canada? First, what are net margins? Secondly, why is it an important criteria of the Chicks Dozen? Straight from the Great White North, I’m here to tell ya. What do you think about that, eh?

Net Margins (also called Profit Margins) -- what exactly are they? The equation looks like this:

Net Margin = Net Income/Sales

Backing up a bit, what the heck is Net Income? Believe me, all these terms sounded strange to me at one time too. I had no accounting or finance background, so if you said Net, I’d say Grant Fuhr (Famous NHL goalie.) If you said Net Income, I’d say, "Don’t you mean In-Coming?" Bare with me, they’ll all make sense by the end of the season, I mean article.

Let’s say the Lone Star Ranch did $100,000 worth of business last year. Over the past 12 months, they have had school after school come through for three-day field trips. Kids are able to ride horses, play in the field, and canoe through the stream. From this, they have taken in $100,000. This would be their SALES figure.

Sales.........$100,000

To find out what their Net Income is, all you need to is subtract their expenses. All of their expenses. You need to deduct every little item on that income statement that has to do with running the Lone Star Ranch. The employees’ salaries, the veterinarian’s bills, the brand new canoes, and the taxes paid on the acres of property. Everything. Luckily for us, the subtraction has already been done for us on the Income Statement so you just need to look for the sub-title that says, Net Income.

On the Lone Star Ranch’s Income Statement, it says,

Net Income.........$9,000

We would then have to divide the Net Income ($9,000) by the Sales ($100,000) to get the Net Margin. What the Net Margin actually tells us is how much the company is making on every dollar after all expenses are deducted; how much profit per dollar the company clears. This is what the equation looks like for the Lone Star Ranch:

Net Income / Sales
$9,000 / $100,000 = .09

This means that the Lone Star Ranch is making nine cents on every dollar.

To change this decimal to a percentage, which is how we like to state it for the Chicks Dozen, we multiply it by 100 (.09 x 100 = 9%). Lone Star Ranch’s Net Margins are 9%!

A while back the Chicks were confused as to why the Net Margins would be more important than the Sales. Easily confused by novices, but now we know why. Let’s say the neighboring "Wild Bill’s Ranchero" down the road also had Sales of $100,000. Both Lone Star and Wild Bill each had $100,000 worth of sales. How can we tell who runs a tighter business of the two horse stables if they have equal sales? Aha! We are looking for the one with the greater Net Margin.

If Wild Bill has expenses of $97,000, then his Net Income would be $3,000. ($100,000 - $97,000 = $3,000) Let’s continue the math and figure out Wild Bill’s Net Margins….

Net Income / Sales
$3,000 / $100,000 = .03

In other words, Wild Bill makes three cents on every dollar. His Net Margins are 3%.

Now, if you were to pick a company to invest in, all streams and fields being equal, and one was making nine cents on every dollar and the other was making three, which would you invest in?

Exactly. Lone Star. I’ll go put my money down for you right now. (Woops, I forgot I was making it up. It’s a theme in the Chick’s Eye View.)

Net margins, simply put, are how much money a company clears in pure profit after all expenses are subtracted. What looks appealing to a Chick is a company that make at least eight cents on every dollar, or has 8% Net Margins.

It’s starting to snow out here in the car so I better run back in and catch the tail end of the Brittany Spears/Christina Aguilera debate. I can hardly wait.

For more on how to find the Numbers on an Income Statement, check out Getting to Know the Financial Statements.

TIE