Stocks With Wide Profit Margins Have Big Potential For Success

Investors looking to buy a great stock should not only study its earnings and sales growth. Be sure to also check out a company's profit margins. Profit margins measure how much a company keeps on every dollar of sales. For example, a company that earns 22 cents for each dollar of sales before taxes has a 22% pretax profit margin.

Profit margins are closely watched by Wall Street analysts and fund managers because they provide an indication of a company's fundamental strength.

In some cases, a company's margins may be rising because it enjoys strong pricing power due to unique or superior products and services versus the competition.

In other cases, a company may be superior at keeping costs low.

Rising profit margins can justify higher stock prices. On the other hand, falling profit margins can hurt a stock, especially if they're caused by a company that's cutting prices to sell its products.

On Jan. 13, the stock of KB Home (KBH) crashed 16% after the homebuilder warned that margins were declining. The company said it was being squeezed by rising building costs and falling home prices.

There are a variety of definitions for profit margin, but IBD focuses on quarterly after-tax and annual pretax margins.

Looking only at quarterly margins can be misleading, as some companies' products or services may be influenced by the seasons.

For example, Apple's (AAPL) sales tend to rise around Christmas, while those of homebuilders such as KB Home tend to fall in the winter due to harsh weather.

In such cases, it's best to compare quarterly after-tax margins to the same period a year earlier.

Also, since profit margins vary widely by industry, it's important to compare companies in the same industry.

For example, tech stocks like Skyworks Solutions (SWKS) tend to have much wider margins than grocery stores like Kroger (KR) that have famously thin margins.

Just because a stock has fat profit margins doesn't mean it's a buy.

Investors should look for accelerating quarterly and annual margins. They should be near or at the company's historical peak and among the highest in its specific industry.

A company's annual pretax margin can be found in the Stock Checkup feature at Investors.com and in charts accompanying the IBD 50, the Sector Leaders, IPO Leaders and Income Investor columns.

A pair of other measures give an indication of a company's strength.

IBD's SMR Rating combines a company's sales, profit margins and return on equity into a single indicator. Stocks are ranked on a scale of A to E, with A being highest. Investors should look for those rated A or B.

The stocks in the table accompanying this story were taken from a recent IBD 50 list. All show strong annual pretax margin in the prior fiscal year.