Understanding Net Margin: Definition, Importance, and Impact on Investments

Net margin allows investors to assess the operational efficiency of companies and their ability to generate profits.

Net margin: definition and importance

Net margin is the ratio of a company's net income to its revenue, expressed as a percentage. This metric illustrates a company's ability to convert its revenue into real profits, after deducting all of its expenses, such as cost of goods sold, general and administrative expenses, operating expenses, depreciation, taxes, and interest.

A high net margin is often considered an indicator of financial strength. It demonstrates effective cost management combined with revenue maximization. Conversely, a low net margin may indicate difficulty controlling costs or exposure to adverse market conditions.

The net margin thus reflects the company's operational strategy, its ability to navigate a competitive environment and its ability to generate value for its shareholders.

Impact of margin variations on stock prices

The evolution of net margin over time can provide valuable insights into the overall performance and long-term sustainability of companies. An upward trend generally indicates improved operational management, greater efficiency in controlling costs and a better ability to generate profits.

Margin improvements are generally greeted by a price increase. Conversely, announcements of margin compression can lead to significant stock market corrections, particularly in sectors where margins are traditionally high. Price sensitivity to margin changes differs across sectors and countries, reflecting the specific expectations of investors in each market.

Advantages of Net Margin over Gross Margin

There gross margin, which is the difference between sales revenue and cost of goods sold, provides insight into the immediate profitability of a company's sales. However, it does not take into account other operating expenses, financing costs or taxes, which can affect actual profitability. Net margin, by integrating all these variables, provides a more complete picture of a company's financial performance. It is often considered a more effective indicator for predicting stock price movements. We will see later, in the backtest, that this is partly true.

On the other hand, gross margin can have some limitations when comparing companies operating in different industries. This is because cost structures vary considerably across industries, making gross margin less relevant for benchmarking in a cross-industry context. For these reasons, gross margin works best when compared among peers, within industries, as we have seen in our last backtest. Net margin, on the other hand, takes into account all the costs and economic realities of each sector. It is therefore more effective for sector comparisons, reflecting the ability of companies to navigate their respective environments.

Disadvantages of Net Margin over Gross Margin

Net margin, by incorporating a variety of expenses, including taxes, interest and other operating costs, can provide more leverage for accounting adjustments to influence financial results. This can include practices such as capitalizing certain expenses or recognizing revenue early, which can mask a company's true financial health.

Conversely, gross margin, which focuses solely on revenue and cost of goods sold, may be less susceptible to such manipulation because it is based on more direct elements related to sales operations.

Comparison of the French and Swiss markets: context

The Swiss market is distinguished by the presence of major international groups in high value-added sectors such as pharmaceuticals, bank and watchmaking. Switzerland's favorable tax environment, as well as its political and economic stability, have a positive influence on companies' margins.

The French stock market is characterized by the significant presence of manufacturing industries and public services whose average margin level is generally more moderate. French companies operate in a tax and regulatory environment that weighs more on their margins.

The structural differences between the two markets are reflected in the average net margin levels. Historically, Swiss companies have posted higher margins than their French counterparts.

Investment Strategies Based on Net Margin

Investors can build strategies based on selecting companies with net margins above their industry average. Theoretically, net margin should also be effective in comparison to the market as a whole, certainly more so than gross margin.

On the other hand, net margin trend analysis helps identify companies that are experiencing operational improvement, which is a signal of financial health and efficiency. Conversely, it also helps detect anomalies and potential warning signs. A decrease in net margin can signal underlying issues, such as rising production costs, operational inefficiencies, or management that is not adapting to changing market conditions. By identifying these red flags early enough, investors can avoid potential losses and adjust their investment strategy accordingly.

Backtest

To assess the effectiveness of this ratio on the Swiss and French markets, I performed a backtest from 2004 to 2024. Stocks were ranked according to their net margin, from lowest to highest, and then divided into quintiles. I used the net margin data for the most recent half-year, as the results are slightly better than using the margins for the previous twelve months. The process was repeated each year during the observation period, allowing for an in-depth analysis of the performance of each quintile.

I also analyzed net margin growth by ranking it by quintiles, from lowest to highest. To do this, I used the growth of the last twelve months compared to the previous twelve months, which gave the most relevant results.

The results have been adjusted to take into account dividends, fractional shares and other corporate events that may influence stock value.

Although margin (and its evolution) is generally considered a better indicator for comparing companies from different sectors, my retrospective analyses show that it is even more effective when comparing with peers within specific industries. Therefore, I will only present below the results obtained with this method, which is the most relevant, as was the case for gross margin.

Backtest results (in CHF)

• Net margin, best quintile CH: 11,25% (market 8,36%, gross margin 10,76%)
• Net margin, best quintile F: 5.84% (market 3.06%, gross margin 4.38%)
• Net margin growth, best quintile CH: 8,75% (market 8,36%, gross margin 13,40%)
• Net margin growth, best quintile F: 3.97% (market 3.06%, gross margin 5.52%)

By company size:

• Net margin: no significant difference for Switzerland, works better for Big and Mid Caps in F (6.57%)
• Net Margin Growth: Works best with Big and Mid Caps, in CH (best quintile 9.80%) and in F (best quintile 6.09%)

Lessons from the backtest

• Gross margin and gross margin growth work in both markets analyzed. Regardless of the country and the chosen indicator, the top-ranked stocks beat the market.
• Net margin works better than gross margin in Switzerland and France.
• Net margin growth performs surprisingly less well than gross margin growth in both countries.
• Net margin growth is performing less well than net margin. This is the opposite of what we saw with gross margin.
• The combination of net margin and its growth does not give good results (not specified above). We have seen the same thing with gross margin.

Gross margin growth (comparison within industries) is therefore still the best performing single ratio that we have studied so far in Switzerland (13.4% per year for the best quintile). In France it is still the dividend yield (within industries) which works best with 7%/year.

Conclusion

Net margin provides a better understanding of a company's ability to generate profits in a complex and changing economic environment. By taking into account all expenses, taxes and interest, net margin provides a comprehensive and accurate view of a company's financial health.

The backtest reveals that net margin is a valuable indicator for anticipating the future performance of a stock. By focusing on stocks with the best net margins, it is possible to outperform the market. However, it should be noted that this indicator does not perform as well as other ratios we have examined so far.