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With Taxes, Firms Have Control Issues

Look at Profit Margins Before Taxes

You can’t ignore your own tax bills, but when you’re trying to find profitable and growing companies within a sector, paying too much attention to taxes can really obscure analysis.  That’s why BetterInvesting recommends looking at pre-tax profit margins when judging how effective management is at earning profits on sales.

Even within the same industry, every company’s experience with the Internal Revenue Service will be unique.  Global companies might be able to repatriate profits from abroad at lower tax rates, an advantage over companies that sell only domestically.  Those global companies might face higher tax levels abroad, though. 

Companies in high-tax states pay more than companies in low-tax ones.  But even companies in the same states might have different tax burdens if managers have cut deals with city hall and state politicians when they’re deciding where to build new stores and factories.  Be-cause tax laws and accounting techniques change, taxes can vary widely from year to year.  There’s only so much a company can do to control its tax rates; therefore, it’s best to remove this variable from long-term analysis.

Companies report pre-tax profits in their quarterly and annual reports.  Dividing the pre-tax profits by total revenue yields the pre-tax profit margin, which represents the amount of profit before taxes earned on every dollar of revenue.  Look at these ratios over the long term (at least five years).  What you like to see are margins that are increasing or at least holding steady.  You should also compare the company’s margins with those of industry peers.

Take Goldman Sachs (symbol GS).  It’s a leader in the investment banking world, but it’s not the largest bank around.  Its pre-tax margin was 21 percent for 2006, compared with 20.1 percent for the industry, according to BetterInvesting’s S&P Stock Data Service.  Over the past five years, Goldman’s average margin was 19.3 percent, while the industry’s was 17.4 percent.  This indicates that Goldman is among the best-run banks on Wall Street, and since the 2006 margin was higher than the five-year average, operations are improving. 

Though it doesn’t happen often, watch out for a company with an excessive margin relative to its industry.  It might imply that the margin isn’t sustainable or that it’s a fluke. 

Lehman Brothers (LEH), a Goldman Sachs competitor, sports much lower ratios than Goldman and shows the opposite trend.  Its pre-tax margin for 2006 was 12.6 percent and for five years was 13.5 percent.  These numbers lag the industry, and it seems that Lehman Brothers’ profitability has slipped.  Also, although Gold-man’s margins for both one and five years are better than those of the S&P 500, Lehman’s are well behind the average for the index.

Goldman’s profitability clearly is stronger and growing, and you could well decide that it’s a high-quality company worthy of further study.  Whether it’s a better invest-ment than Lehman can be determined only by coupling this analysis with a study of the companies’ growth prospects, valuation and potential return.  Remember that investors often reward high-quality companies, as indicated by their historical growth rates and profit margins, with higher price-earnings ratios.  (This article is for educational purposes only.  No investment recommendation is intended.)

Although tax rates are largely out of management’s control, chief financial officers and their armies of accountants have some accepted ways of avoiding handing shareholder profits to tax authorities.  The most common techniques include consolidating losses from subsidiaries to reduce the profits they report to the IRS and collecting tax credits for research and development spending.  In the end, shareholders can only collect what the government doesn’t. 

After-tax profitability really is the bottom line.  But pre-tax numbers help investors focus on management’s true ability.

BetterInvesting’s Online Tools
This article pertains to studying management effectiveness on the Stock Selection Guide, the primary stock study tool of BetterInvesting members.  Our new online tool will walk you through evaluating a company using the SSG.  Click on the Online Tools & Software link under the Tools & Resources menu on the BetterInvesting homepage.  Your membership may already include access to the tool; if not, you can upgrade your membership to use it.

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