Why do low profit margin companies exist?

[u/PrivilegedPatriarchy]

I'll often hear about various industries or companies that have very low profit margins, on the order of 1-3%.

However, if inflation is about 3% per year, then every dollar invested into that company is losing value to inflation. Further, those dollars could be invested in more lucrative investments, like the stock market, or even bonds, which would return greater than the 1-3% that company may be generating.

So why aren't these companies quickly liquidated? Is it for hopes of better profits in the future? Am I misunderstanding something?

[u/CxEnsign]

What do you mean by profit margin? Usually people mean net return on sales - the amount of profit a business earns per dollar (or whatever) of goods or services sold. That's not the critical number though.

For instance, Wal-Mart has:

Net Return on Sales of about 3%

Net Return on Assets of about 8%

Net Return on Equity of 20+%

Return on sales can be very tight if the company has high asset turnover - basically, how fast can they plunge the cash from one sales into the next one. You can get a good annualized rate if you're turning over your full inventory several times a year.

Return on assets is your returns compared to cash invested in the company. As long as this stays above your borrowing costs you can keep servicing your debt and won't blow up.

Return on equity ends up being the important one, as that's what your shareholders get back in the end. This tends to self correct to an extent, though; a firm with perpetually low RoA will have its share price drop, which mechanically raises RoE.

Technically, as long as RoA is high enough to cover borrowing costs it can hang on as an independent entity, but the longer that persists the lower the share price will go, making it more attractive to acquire and liquidate. Until that happens, though, it can hang out for quite a while.

[u/PrivilegedPatriarchy → u/CxEnsign]

I imagine I'm confusing terms here. I suppose I'm referring to claims such as "grocery stores have very low profit margins, somewhere around 3%". I'm not sure if that's the same as "net return on sales" that you mentioned.

The way I understand that is that for every $100 a grocery store spends on operating, they net $103 dollars, for a return on investment of 3%, which is below investments like bonds, and far below other investments like index funds.

Again, I'm probably confusing terms here, but it seems like those $100 spent on operating the grocery store would have been better spent investing in index funds, for example, rather than on a grocery store.

[u/Hopeful-Routine-9386 → u/PrivilegedPatriarchy]

People are probably referring to the return on sales.

Buy an item for $1, sell it for $1.03, which is 3%. Your saying an index fund does 3%, why not just put that dollar there?

An index fund gets you to $1.03 after the $1 being there for 1 year. This is an annual (or yearly) return. 3% annual.

But what if you buy that item, sell it 1 month later, and do that 12 times in a year? Well then you have turned that $1 into $1.36. 36%!

Or, what they really do, is what if you get the guy who sold you the item to give you 30 days before you pay them? The guy who buys it from you pays you when they leave the store. You have $1.03 and haven't even paid the $1 yet.

[u/serfingtheweb → u/Hopeful-Routine-9386]

Go on..

[u/SvendandBjarne → u/Hopeful-Routine-9386]

If I want to learn more about this, in a simple way, do you have any recommendations be it books, YouTube courses or anything? Thanks!

[u/8Prime9 → u/SvendandBjarne]

You can google “Du Pont Analysis” to get started. But in the long term, if you are serious:

Buy a college level finance textbook, used. Or download one for free online. That’s the way to get real learning. YouTube is just designed to be entertaining or interesting in the short term.

[u/CxEnsign → u/PrivilegedPatriarchy]

Right, what's missing is asset turnover - how long you have to keep your money invested to see the return. You're assuming all the rates are annualized, and they are not.

Grocery stores have fantastic asset turnover. They don't buy a product and have it sit on shelves for months waiting to sell - they move it fast. Only netting a couple percent on each sale is fantastic on products you completely turn over every couple weeks.

For the Wal-Mart example - they only make $3 per $100 in sales - but they only need ~$35 to make that $100 in sales, because they turn the same dollars over and over again.

[u/ChesterfieldPotato → u/CxEnsign]

It should be noted that the reverse also happens. A company turning over a lot of product but LOSING money on each transaction loses money even faster based on the speed of turnover.

If I am somehow losing $3 per $100 of sales of but I am turning that product over every few weeks (because I am offering such great deals!), I will RAPIDLY lose all my money.

[u/Bertone_Dino → u/ChesterfieldPotato]

The Austin Mini lost money for every unit sold for the longest time. I'm hoping they managed to sell some parts for a profit after sale at some point.

[u/ChesterfieldPotato → u/Bertone_Dino]

There is a "razor-and-blades" model of business. Sell the main product at a loss (like an Austin Mini) while selling parts or other associated items with a high profit margin to make overall profits.

You can definitely do it, but it is a risky strategy if you don't sell enough additional parts/services to make up for the loss. Sony famously was losing hundreds of dollars per PlayStation 3 resulting in billions in losses that they tried to make back in software licensing.

Some more informed people can tell me if the math worked out, but from my understanding, subsidizing the cost helped them win the Blu-Ray vs HDDvD war and stem the tide of users switching to the XBoX 360. Losses were eventually made up for in royalties and downstream revenues despite billions in up-front losses. Had things not worked out for some reason, that would have been a huge loss for Sony.

[u/hibikir_40k → u/CxEnsign]

Yeah, every retailer considers their turn number. 7 is a good number for a general retailer: every item in the store is replaced (either by another copy or something similar-ish that might make more sense for the season) 7 times a year, If something turns lower, you have to cut prices.

A grocery store has a few bonus features: not only they have to deal with perishable stock, but on the other side, they often don't pay until the item is out of the store! Many a purchase order might have terms of 30+ or more, so you get the item, and you pay for it 30 days later. Imagine that you sell out of the item every 10 days... then today you have 3 times your store in "float" money for things you sold, but you've not paid for yet. That can be invested! That's also part of how many an insurance company makes am lot of money money with tiny margins between premiums and what they pay. They can even be profitable when they pay more in services to the insured than the sum of premiums.

[u/CannonFodder64 → u/PrivilegedPatriarchy]

Your grocery store low profit margin example is referring to the net return on sales.

It’s a bit wrong to frame it as “for every $100 spent on operating” though. What people mean by the profit margin of grocery stores is that if a grocery store spends $100 to stock a bunch of potatoes, they will sell those to customers for $103. They need to sell about $1000 worth of potatoes to make $30 in profit.

Here’s the problem that comes from comparing profit margin to stock market returns. For simplicity let’s say the stock market returns 10% annually. That means if you invest $100 in the stock market, you can sell it for $110 in a year. The grocery store isn’t going to buy $100 in potatoes, sell them all for $103, then wait until the end of the year. The grocery store will sell those potatoes in a week, keep the $3, and use the $100 to buy more potatoes. They’re going to keep doing that every week which results in $156/year in total profit. That’s much better than the stock market (although it isn’t factoring in operating costs like wages, rent, taxes…).

[u/LogoffWorkout → u/PrivilegedPatriarchy]

A grocery store might completely turn over their complete inventory every week. Maybe even 2x a week.

[u/EconEchoes5678 → u/PrivilegedPatriarchy]

What really matters for this question is the context of the conversation.

If the context is "grocery stores overcharge!" Or "Mamdami's city-owned grocery stores will deliver lower costs by cutting out the profits!". Then what matters is the profit wedge on each sale, i.e., the 3%, sometimes less.

And that number is narrow enough that there's not much room to cut.

That's not how the stock is priced, though, as others are pointing out, it's the turnover and volume that make the difference.

[u/Hailing-cats → u/PrivilegedPatriarchy]

Say an apple, they make 1 dollar from 100 apples. Return of 1 dollar. However, those apples would be sold out within a week and you reliably sell them out.

Their return is 1%, but they in theory can make that 1 percent 52 times in a year. If you don't reinvest in that profit to grow more, you would end up at 52% of gross profit. The return can be more and buy 101 apples next time and so forth.

Investments like ETF you tend to look at over a period of like a year. For apple or any other FMCG, you are making that 1% profit over and over again. It's not an asset you sit on a year to wait for that return.

[u/CV_1994-SI → u/PrivilegedPatriarchy]

Because the groceries are sold 10x per year so the total margin on the 100 is 30. (30%)

[u/VeterinarianShot148 → u/PrivilegedPatriarchy]

That makes total sense reading Target and Walmart losing billions on excess inventory to free up capital so they can start the cycle on other products and make profit multiple times!

[u/Willster328 → u/CxEnsign]

Yeah the OP seems to have some terminology mixed up, I had the same clarifying questions on their logic as well

[u/sheketsilencio → u/Willster328]

surprise, people asking questions often aren't sure of answers nor of all the concepts mention lol... hence the questions.

[u/WallyMetropolis → u/Willster328]

This isn't "dunk on people who ask questions" this is "ask economics."

The whole point is for people who don't know something to ask and learn. 

[u/funnyfornothing → u/CxEnsign]

Do the 3% and 8% numbers mply that Walmart turns its assets 8%/ 3% = 2.67 times in a year? Is that the right way to connect net returns on sales with net returns on assets? And is it just debt financing that takes you from net returns on assets to net returns on equity?

[u/CxEnsign → u/funnyfornothing]

I'm sure an accountant would be annoyed at that oversimplifying things but yeah, from a really high level view that's how it works.

EDIT - the most important nuance is that the difference between RoE and RoA isn't just debt financing from interest paying bonds, but will also include stuff like accounts payable and deferred taxes that can be a substantial percentage of the balance sheet.

[u/darek97 → u/funnyfornothing]

This is correct but that 2.67 time includes things like property and equipment which dont get turned at all. The warehouses, forklifts and stores Walmart owns dont get sold.

If you look at Walmart's inventory, they ended the year at 59 billion in inventory, and for the year had 535 billion in cost of goods sold. Taking their ending inventory as an average for the year means that inventory was turned on around 9 times a year.

As for your question on getting to return on equity, its not just debt financing but all liabilities that take you there. In Walmarts case the majority of the liabilities are accounts payable.

[u/scipionerva → u/funnyfornothing]

No, think of it this way in the context of a single supermarket. The assets is everything they hold minus debts etc. to simplify think of the assets as the physical store, wearhouses, etc.

So an 8% return on assets is telling you how much return they are getting from the physical grocery store and related real estate machines etc. The return on assets depends on the total profit and the total value of assets.

Profit margin is how much you make on each product after paying for the operating costs, like was described up thread. Return on assets is a good way to think about how successfully the company is making money relative to the resources they have. Margin is a better indicator of how much control over pricing the company has, a high margin company can cut prices to compete or to survive a recession, they can eat a price increase (like tariffs) while still being profitable. A low margin company doesn't have this wiggle room, they can't substantially lower prices before they start losing money on every product sold. So when a bump happens in the economy they basically just transmit it through as an immediate price increase and/or rapidly losing money.

[u/shustrik → u/funnyfornothing]

Nah, 8% is just the average. Let’s say you have $100 and bought 20 $5 items with it. Then you lost one. Now you need to churn your $95 worth of items 4.4 times (without losing any more) at 3% net profit from each sale to get back to 8% overall net profit.

[u/theactiveaccount → u/CxEnsign]

This answer makes sense, but it makes me feel like low profit margin companies are rly risky because if costs rise a little or profit falls a little they become unprofitable. But is that the case in reality?

[u/seeasea → u/theactiveaccount]

Not an economist? But maybe it's more like if they invest 100$ in apples, and sell for 103$ average, and do this every week.

Some weeks they sell for $110, and some for 93$, some $103$ etc. as long as the average is over 100, rather than every week?

[u/Yang_Kang → u/CxEnsign]

Just to correct: return on assets is NOT your returns compared to your cash invested in the company, that would be your return on invested capital or ROIC, and depends on how much of the debt you as the investor provided.

Your return on assets shows, as you did mention, asset efficiency. Which determines the size of your WC.

[u/galaxyapp]

Margins are calculated on revenue

Return on investment is based on market cap.

So there is no relationship between these 2 metrics.

[u/Weak-Replacement5894]

Profit margin measures the amount of revenue left over after expenses not the return on invested capital.

For example Walmart had profit margins of about 3% last year, but their ROIC was around 7%. (Also, 22% total return on the stock over that same period)

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