Earnings and EPS numbers are great metrics that all investors and analysts should review as part of the research process. But the problem with earnings data is that it can be easily manipulated by one time gains, tax benefits, and/or the sale of discontinued operations. With that in mind, a better way to gauge a company's progress is to evaluate its "margins", and its margin growth. After all margins are probably the best indicator of a company's true profitability and are also an excellent indicator/predictor of future stock price performance.

But before I delve into the nitty gritty to prove my point of how margins can make or break a company and how valuable they are as an analytical tool, it's important that you, the reader, understand exactly what is meant by the word "margins."

To be clear the term "margin" is typically used in a general sense to characterize three different types of margins, all of which can be found in or calculated from a company's income statement. The three types of margins are: gross margins, operating margins, and net margins.

Gross margins are defined by the Investopedia dictionary as: "A company's total sales revenue minus cost of goods sold, divided by the total sales revenue, expressed as a percentage." In other words gross profit divided by total net sales. As an example, in numerical terms it looks something like this: $100,000 (Sales) - $80,000 (Cost of Goods Sold, aka raw materials) = $20,000 / $100,000 = 20% gross margin.

Operating margins are defined by the Investopedia dictionary as: "Operating Income divided by Net Sales." As an example, if a company had $10,000 in operating income (which is the amount left over after paying for things like labor, and overhead) and $100,000 in sales, its operating margin would be 10%.

Finally, net margins are defined as net income divided by net sales, expressed as a percentage. As an example if a company had $5,000 in net income (which is the amount of money that's left over after paying taxes), and total net sales of $100,000, its net margin would be: Net Sales $5,000 / $100,000 = 5%.

With all of that in mind what is really important to note here is that while it's relatively easy to manipulate a company's net income number by adding or subtracting one time items, it's very hard to manipulate all three margin numbers, particularly the gross and the operating number. Why? Because these numbers don't include one time items or non-operational data. In fact, most of the shenanigans that management's use to boost their income line takes place below the operating line (for more, read Detecting Two Tricks Of The Trade)

To put the issue into better perspective, and to demonstrate how valuable margin analysis is consider the following examples:

Boeing (BA): From 2003 to 2006 Boeing grew its gross margins from 12% to 18%, grew it's operating margins from a paltry 0.8% to 4.9%, and grew it's net margins from 1% to 4%. During this same time, its share price went from $31.51 a share to $88.50 a share (in spite of some stumbles in its net income line along the way). Coincidence? I think not!

McDonald's (MCD): Have you seen McDonald's stock over the past year? It went from $32.72 to more than $45 a share – a 38% jump! Why? Consider that between 2005 and 2006 its operating margins increased from 20% to 21%, and its net margins increased from 13% to 16%. (Note: McDonald's does not break out gross margins). Again, is this correlation between margin growth and the share price a coincidence? Not a chance.

With that in mind investors should also consider how companies that sport comparatively high margins (not just those that show solid margin growth) tend to see their stock price appreciate at a faster rate than those with lower margins.

As an example, consider Wendy's (WEN). Over the past year its stock went from $25.58 to $32.89 - a 29% increase. Not bad. But why did Wendy's stock increase at a slower clip than McDonald's? Part of the reason might be that their operating margin in 2006 was about 2%, well shy of the 20% number that McDonald's turned in.

Burger King (BKC) is in the same boat. Its stock increased from $17.45 (in May, 2006 when it went public) to $20.96 – a 20% jump. It's operating margins? In 2006, they came in at roughly 8%, which again was well south of the McDonald's number.

Hold the email folks. Sure some of the discrepancy in stock price performance can certainly be attributed to McDonald's' superior market position and impressive operating history. But one could also argue that the McDonald's business is more mature, and that many of the markets in which it operates are saturated. This leads me back to my point -that margins are indeed a harbinger of future stock price performance.

Need further evidence?

Take a gander at Coca Cola (KO) and Pepsi (PEP). Coke trades at roughly 22 times this years earnings and 18.8 times 2007 estimates. Its gross margins are 66%. Its operating and net margins are 26% and 21% respectively. Meanwhile Pepsi trades at roughly 19.22 times this years earnings and 17.4 times next years estimates. Its gross margins are 55%, and its operating and net margins are 18% and 16% respectively. In short, while Pepsi's performance is solid, its inability to match Coke's margin numbers in an absolute sense is certainly a major reason why it trades at a lower multiple.

Next, take a look at Apple (AAPL) and Hewlett Packard (HPQ). Apple trades at roughly 37 times 2006 earnings and just north of 26 times 2007 forecasts. Its gross margins in 2006 were 29%, and its operating and net margins were 13% and 10% respectively. Meanwhile Hewlett Packard trades at about 19.6 times 2006 earnings, and at roughly 17 times 2007 forecasts. Perhaps not surprisingly, its margin numbers were much lower than Apple's. In fact, its gross margins in 2006 were just 24%. Its operating and net margins were roughly 8% and 7% respectively.

Bottom Line:
Although margins are not the be-all-end-all they are a very important factor when analyzing public companies. Pay particular attention to margin trends, meaning both increases and decreases in gross, operating and net margins because they are an excellent indicator of stock price performance. In addition, keep in mind that often companies with higher absolute margins will outperform those with lower margins.

For more on this topic I'd recommend checking out The Bottom Line On Margins, Fundamental Analysis: Introduction and Financial Statements: Introduction.

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