Before outlining the reasons behind focusing on profit margins when making investment decisions, I find it ideal to explain what "profit margin" actually means for those who are new amateur investors. Basically, profit margin is written as a percentage which refers to the proportion of net sales that becomes net income after all expenses are taken into account, which normally includes tax.



Therefore, a high profit margin means that the company is controlling its costs very well, which is what investors all look for. On the other hand, a low profit margin indicates a low margin of safety meaning that a decline in sales could quickly erase profits and result in a net loss.

The above explanation clearly demonstrates how advantageous it can be to be aware of the profit margins of a company. Nevertheless, Warren Buffett has his own way of using profit margins which have brought him so much success over the years.

The Buffett methodology revolves around historical profit margins. That is, profit margins recorded over a number of years in the past. A good strategy is to go back at least 5 years and see how profit margins have evolved since. In total there are 3 types of profit margin patterns that an investor can observe and the reason why they should each be understood is explained below.

The first type of pattern is a consistent profit margin. This basically means that in the last 5 years (or whatever number of years you choose to use) the profit margin has remained relatively stable. This is good news if the profit margin is high means that management has successfully been able to control any growth in expenses. However, it is bad news for any investor if this is low.

Another common pattern is that of an increasing profit margin over the time period chosen. This is obviously good news for any investor, but before making any decision to invest, it may be wise to go through other parts of the Buffett methodology explained in the 4 previous articles of this series.

A final common pattern is that of a decreasing profit margin over the time period chosen. This is evidently bad news for any investor and it is highly recommended that investors stay away from companies which have this characteristic. Nevertheless, it would be premature to say that such a company is not worth investing in without looking at other parts of the Buffett methodology.

Overall, Buffett's successfully methodology is based on 5 principles, which are all fully outlined in my articles for your own benefit. Any investor which is not aware of his strategies would be foolish not to study them. That said, you should not limit yourself to Buffett's way of investing. There are many great and useful strategies out there, which I will be writing about in the next couple of days. Stay tuned!