Skip to main content

Lemonade Stand Part One: Profit Margins



 Over the next four posts, I am going to post short stories and explanations on important stock metrics. I am going to cover dividends, debt, P/E ratio and more. These stories are meant to be easy enough for a child to understand. Throughout the stories, there will be four characters, Farhang(Father), Kristin(Mother), and their daughters Lily and Sara. Lily and Sara open up their own lemonade stand but they have some troubles, sometimes it rains so they don’t get enough customers and other times their father, Farhang, just can’t wrap his head around the concepts.


Profit Margins:


We are going to start with Profit Margins. This story will take you step by step on how to calculate the Profit Margins of any company you have interest in. Sources such as Morningstar and Motley Fool help you find the exact calculations without doing the research but you should at least know how to find the data you need and how to calculate it. As an investor it’s important to know why I’m making you read this post, why I’m even talking about this. Well, it’s because the money or the profit that the company makes determines how much the investors will get.


There are many kinds of Profit Margins. Think of it like a book, the section is Profit Margins but to calculate it there are many ways and many different types of Profit Margins. The most common one is called Net Profit Margins. First we are going to look at a big picture idea, showing Lily and Sara’s Lemonade Stand’s Profit Margins. Next, we are going to look at NPM(Net Profit Margins) for real companies, Walmart and Johnson and Johnson.


Lily and Sara are selling their lemonade for $0.50 a cup. Farhang bought $8.00 worth of cups, sugar, and lemons for the two girls to start their lemonade stand. If they sold $10.00 worth of lemonade and had to pay $8.00 back to Farhang. What is their Profit Margin?


Let’s calculate together. If they spent $8.00 on the ingredients and subtracted that from the amount they sold $10.00, you would get $2.00 of profit. Then you would divide $2.00 by $10.00 which would give you one/fifth, otherwise known as 20%. When the girls sell $10.00 worth of lemonade they would have a 20% Profit Margin.
$10.00(of Revenue) - $8.00(the cost of the ingredients) = $2.00(of profit)
Now on to NPM (Net Profit Margin). It’s an easy but very helpful tool. Let’s first learn how to calculate it and then look at some examples. To calculate Net Profit Margins you need to know a few vocabulary words. Net income: Net Income is the profit that the company makes. In the lemonade stand example, the girls Net Income was $2.00. The last word is Revenue, that is not the same thing as income. Revenue is all the money that the company earns, again, Lily and Sara’s Revenue is all the $10.00, it’s profit and all.
We explained how to calculate income, but as a recap, you take how much you made and subtract that from the total cost of the items you needed to buy to make the company’s product. For example, when Farhang paid for Lily and Sara’s lemonade stand he had to buy all the ingredients so they could make their lemonade. It ended up having total cost of $8.00. To calculate NPM you have to complete three steps.
  1. Find the Net Income.
  2. Then divide the Net Income by the Revenue.
  3. That brings us to your total percentage of Net Profit Margins.
It’s important to know three things. When you divide the Net Income by the Revenue it means that the Net Income goes into the Revenue. The second thing is when you’re looking at stocks to invest in you want to check and see what the difference between the NPM of the company compared to the Industry Average. Preferably the company’s NPM is higher than the Industry average. The third thing is where you’re looking. You can find the industry average of most metrics next to the metric you are looking at, for all the example in this post I am using the data source Morningstar.
Now, let’s look at some examples.
I am going to use Johnson and Johnson v.s. Walmart. Johnson and Johnson is a medical company, they make toe tape, medicine, medical devices, body wash, shampoo and so much more. Walmart is a chain store that sells groceries, school supplies, Polaris golf carts and much more.
When you look on your preferred website (remember, Motley Fool or Morningstar are two options) to find the data for a stock you want to look for two things the Net Income and Revenue. First, we will look at Johnson and Johnson, ticker: JNJ. Their Revenue for 2016 is $70.8 Billion and their Net Income is $15 Billion. Now what we want to do is divide $15 Billion by $70.8 Billion. That gives us a NPM of 21%, meaning for every dollar Johnson and Johnson makes for Revenue the company earns $0.21. If we look at Walmart they have a Revenue for 2016 of $483 Million and a Net Income of $15 Million. When we do the division that would give us 3%, meaning, again, for every dollar they make as Revenue they keep $0.03.
$15,013(Net Income) / $483,208(Revenue) = 3%
Screen Shot 2016-08-13 at 1.27.03 PM.png
Screen Shot 2016-08-13 at 1.24.53 PM.png
If I went to Walmart and spent $100, then Walmart would only make $3.00 of profit. Which means as a consumer they are giving us cheap products, but for a short term investor, it isn’t ideal.  If I bought $100 of Johnson and Johnson products, they would make $21.00. Walmart may look like a bad stock for short term investing, but look at the long run.
If we look at Walmart’s long run compounding. After 44 years they made over one million dollars. I used longrundata.com to find this information.
Screen Shot 2016-08-13 at 1.33.40 PM.png
Johnson and Johnson didn’t do so badly either over the same 44 years.
Screen Shot 2016-08-13 at 1.51.30 PM.png


It’s also important to see if the company’s Profit Margins are increasing or decreasing. Let’s look at the past five years. As you can see they both were pretty consistent. Over five years Johnson and Johnson went up six percentage points compared to Walmart’s zero.
Profit Margin Comparison

2012
2013
2014
2015
2016
Johnson and Johnson
15%
19%
21%
21%
21%
Walmart
3%
3%
3%
3%
3%

Next, we will be talking about debt. You will get to hear more about Lily and Sara’s lemonade stand. After that, you still get to look forward to stories about P/E ratio and dividend! Please post comments and questions below. I would love to answer them.

Comments

Popular posts from this blog

Monsoon Pabrai Prevailing with Force

Lighthouses in Monsoon’s Words “My lighthouse would be knowing when I am not happy, finding my purpose. When you are not having fun, something is wrong. My family is my lighthouse. They helped me to realize I was not happy and try something else.” Monsoon Pabrai, is like her name: she prevails with force. She was born into the world of finance. Her father, fund manager Mohnish Pabrai, tried to encourage Monsoon and her sister to be as fascinated with investing as he is. She graduated from the University of California Berkeley in 2017, but don’t let her short career fool you. Monsoon is the current marketing and community lead at Coral Labs, a start-up company. Prior to working at Coral Labs, she was an investment analyst intern at the UCLA Foundation and worked as a research analyst for Dalton Investments. During dinner, if her father was excited about a recent investment, he would break it down for Monsoon and her sister. She became curious and wanted to invest on her o

The Bank that Stood the Test of Time and Tides

On December 26th, 1993, Robert Gaughen took over Hingham Institution for Savings as CEO during a tumultuous time for the bank. A former Hingham president was arrested on charges that the illegally approved loans costing the bank millions, and for which he allegedly received $240,000 in illegal payments.  The bank was also underperforming. Non-Performing Assets were $9.4 million in 1992, 6.2% of assets, which were quickly reduced by 90% to $0.9 million, 0.62% of assets, in 1994, and only continued to improve from there. Asset quality is critical to the survival of a bank, and along with these improvements, Hingham began paying a dividend in 1994.  *Source: Hingham Institution for Savings’s 1994 Annual Report  Over the next 26 years, the company’s loan quality improved, its branch network expanded outside of Hingham, Massachusetts, and Book Value per Share grew 14 times. The company’s share price has grown 15.6% per year (including dividends).  *Hingham Institution for Savings’s 2018 Ann

The Power of Investing

Recently I talked at my school about investing. I will be singling out the Humility Curve for an upcoming post if you found that interesting.Scroll down to learn more about kids and investing, the power of investing, and my Brother's Stock Researcher .