Profit Margins. For a business, profit margins are the difference between incredible success and incredible failure.
Maintaining big profit margins is no easy task — only a few companies can maintain large profit margins over long periods of time. In it’s heyday Microsoft (MSFT) sported net profit margins of nearly 40%. These days 20% is a more typical number for the software giant.
On the opposite end of the spectrum, sellers of commodities often experience very low profit margins. Kroger is a good example here. The big grocery store operator sees very small profit margins of 1%-2%.
Both Microsoft and Kroger have revenues that exceed $90billion annually, but the difference in the cash they generate is startling — Kroger recently brought home $1.5 billion in profits, and Microsoft’s exceeded $20 billion.
This reminds me of the old saying, “It’s not what you make, it’s what you keep.”
I know what you’re thinking, “So what! Higher profit margins just means Microsoft’s stock price is expensive. Kroger is actually growing faster!”
While it is true that Kroger is growing faster, there’s more to this wealth building game than revenue growth. After that cash gets earned, any number of interesting things can happen — Cash can be used to reinvest in the existing business, buy back shares, pay dividends, or even expand into new lines of business.
Over time those reinvesting activities will either add considerable value to the business, or subtract from it.
In Microsoft’s case, it took over a decade before the business value was realize in the form of a higher stock price. Partly, this was Microsoft’s own fault — they wasted A TON of cash on overpriced business purchases which eventually failed (anyone remember Aquantive or Nokia?).
Today, both companies are well run, and they both pay steady growing dividends. Over the long term, reinvesting made the biggest difference in the overall wealth result (100% higher!). More cash reinvested at high rates of return can really move the needle.
This is exactly what Buffett means when he says, “In the short-term the stock market is a voting machine, but in the long term it’s a weighing machine.”
The “weight” of reinvested earnings makes a real difference in company value. Given enough time, that difference should be reflected in the stock price.
What’s Your Profit Margin?
There’s several important lessons about life and investing we can learn from this real-life wealth building.
For example, you might have a co-worker that’s on the corporate ‘fast track’. As a result, every year this co-worker gets a bigger raise than you, and he (or she) can increase spending.
But these big raises come at a cost — That co-worker works 80 hours a week and doesn’t have a family.
When you drive home at night, do you envy that success? Is working those longer hours and kissing-ass for that bigger raise the best way to build wealth?
Not necessarily! If we think back to our Kroger and Microsoft example, there’s more than one path to building wealth.
Just like Microsoft, you don’t need incredible growth rates to build wealth… as long as you’re saving enough. If you keep a high saving rate for long enough, your net worth will grow quickly.
This is exactly what happened in my own career — I didn’t reach financial independence because of large raises every year! I reached financial independence because my profit margins were higher. I saved more, and reinvested all of my excess cash into good businesses.
That’s right, I rarely saw an annual salary raise over 3% during my 15 year working career… despite working 50 hour work weeks, and often working on the weekend.
A high-level of productivity was considered perfectly normal in my industry. It’s a very competitive world, and standing-out from the crowd isn’t easy.
Unsustainable Job Earnings
Don’t get me wrong, if you can grow your salary faster than inflation, that’s great! Keep doing it! But for the love of money, don’t spend it all!
On a typical human timeline, your job income simply can’t grow forever. Eventually something is going to happen that upsets the income applecart — Maybe you’ll get pushed out by a youngster on the fast track to “success”, a big layoff happens, or those long hours simply deteriorate your health.
There’s a million reasons why it can happen, but it’s most important to know the result — job income growth eventually stops. Live long enough and you’ll experience it.
If you’ve kept your spending low, when that income drop happens it won’t be a major hit to your lifestyle. You’ll be able to live off the earnings from all that invested cash.
Simply put, saved money can work longer and harder than you ever could at a job.
Start With The Big Stuff
So how does a person go from being a 2% saver to a 50% saver?
You start with the “big stuff”, cutting out waste from the biggest expenditures in your annual budget. For most Americans, these expenses will be Housing, Transportation, and Food. Those three expenses alone consumed 60% of the average American family’s spending.
How do you trim those expenses? You sell that 3 thousand square foot home and buy a smaller one closer to work. You get rid of that giant luxury SUV, and drive a smaller/older vehicle instead. You move closer to work so you can walk, ride a bike, or take the city bus. You cut food expenses by cooking your food at home.
Boom! Just by making those four changes you’ll have made huge progress toward growing your own profit margins. Maybe your savings rate will reach 50% on those changes alone… but why stop there? Keep going!
There’s no reason why you can’t go on to save 60% or even 70% of your income. This is where all the “small stuff” really comes into play — like clipping coupons, saving electricity, or giving up Netflix.
There’s a million little things one can do to save money, but get the “big stuff” right first, so there’s room for the small things to matter.
The best money advice I was ever given, was to run my life like a successful business. There are many possible paths that lead to success, but commonalities exist between them.
Good profit margins (aka savings rates) are one of those commonalities. The best businesses continually find a way to keep costs low so that profit margins remain high. It’s both investing advice and personal finance advice.
Year after year, the best businesses seek to widen that gap between income and expenses. It takes continual effort — This isn’t something you do once and then you’re done.
It reminds me of a quote attributed to Carlos Sicupira, “Costs are like fingernails, they always have to be cut.”
Have you trimmed your costs lately?
[Image Credit: Flickr]