A company's net profit margin tells you how much after-tax profit the business makes for every $1 it generates in revenue or sales. Profit margins vary by industry, but all else being equal, the higher a company's net profit margin compared to its competitors, the better.
There are some notable exceptions, but that would require getting into a complex analysis of something called the DuPont Return on Equity formula, which is beyond the scope of this lesson. The short and sweet version: It is possible for a business to make more absolute net profit by focusing on lowering its net profit margin and driving sales through the roof as customers are attracted to its stores. Wal-Mart is a perfect example of this approach, as it has a much lower net profit margin (3% to 4%) compared to a retailer such as Dillard' (7% to 8%), the regional mall department store, yet Wal-Mart earns almost 34x the total net profit because it sells exponentially more goods. There is a danger in this approach, especially when dealing with high-end brands. Lowering prices to drive sales is often called "going downstream". Once a retailer has lost status in the mind of the public, the business can begin to suffer. This is the reason you have never seen, nor are you ever likely to see, a single sale or discount at Tiffany & Company.
How to Calculate the Net Profit Margin
To calculate net profit margin, several financial books, sites, and resources tell an investor to take the after-tax net profit divided by sales. While this is standard and generally accepted, some analysts prefer to add minority interest back into the equation, to give an idea of how much money the company made before paying out to minority owners (often, these are people who still hold a substantial stake of 20% or less; e.g., a successful family that sold 80% of its business to Berkshire Hathaway, yet retained the remaining stock as a private holding). Either way is acceptable, although you must be consistent in your calculations. You want all companies must be compared on the same basis.
Option 1: Net Income After Taxes ÷ Revenue = Net Profit Margin
Option 2: (Net Income + Minority Interest + Tax-Adjusted Interest) ÷ Revenue
Again, it is important to reiterate that, in some cases, lower net profit margins represent a pricing strategy and are not a failure on part of management. Some businesses, especially retailers, some discount hotels, or some chain restaurants, may be known for their low-cost, high-volume approach. In other cases, a low net profit margin may represent a price war which is lowering profits, as was the case with the computer industry way back in the year 2000.
Net Profit Margin Example
In 2009, Donna Manufacturing sold 100,000 widgets for $5 each, with a cost of goods sold of $2 each. It had $150,000 in operating expenses, and paid $52,500 in income taxes. What is the net profit margin?
First, we need to find the revenue or total sales. If Donna's sold 100,000 widgets at $5 each, it generated a total of $500,000 in revenue. The company's cost of goods sold was $2 per widget; 100,000 widgets at $2 each is equal to $200,000 in costs. This leaves a gross profit of $300,000 ($500k revenue - $200k cost of goods sold). Subtracting $150,000 in operating expenses from the $300,000 gross profit leaves us with $150,000 income before taxes. Subtracting the tax bill of $52,500, we are left with a net profit of $97,500.
Plugging this information into our formula, we get:
$97,500 net profit ÷ $500,000 revenue = 0.195 net profit margin
The answer, 0.195 [or 19.5%], is the net profit margin. Keep in mind, when you perform this calculation on an actual income statement, you will already have all of the variables calculated for you. Your only job is to put them into the formula. (Why then did I make you go to all the work? I just wanted to make sure you've retained everything we've talked about thus far!)
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.