How Investors Can Profit by Focusing on This One Key Business Statistic

Few business statistics are more important than net profit margins. That term is defined as what percentage of each dollar of sales finds its way to a company's after-tax bottom line. With some companies that number is fairly consistent. With others it can vary quite dramatically.

Understanding what to expect in this regard can lead to spectacular failures or triumphs for stock traders. It explains much of what already happened to a stock's price and can be quite predictive about what's likely to occur next.

Buying shares when margins are unusually and perhaps unsustainably high is extremely risky. Taking positions when profit margins are extremely depressed but likely to rebound can make fortunes for investors.

You can find historical net profit margin data for most stocks in Value Line, S&P, Morningstar and other readily available sources.

Here are two examples of companies at both extremes of the variability scale.

CVS Health Corp. (CVS) is a bastion of predictability. Its profit margins have held in a narrow range dating all the way back to 2009.

A quick glance at the chart above shows all my normal assumptions for the stock's past share price movement were clearly in effect. When CVS was cheap (green-starred periods) it never failed to rebound. The stock's two obvious "should have sold" moments (red-starred) both came when CVS commanded price-to-earnings (P/E) multiples that were well above average.

My very conservative $105 per share, 18-month price projection for CVS assumes just a 14x multiple, rather than the stock's average P/E of 14.9x from 2010 through 2017. That might end up proving way too modest. CVS fetched north of $113 during 2015, when earnings per share were on pace for just $5.16.

Consistent margins make analysts very happy. Creating a forward EPS estimate then becomes as simple as multiplying expected year-ahead sales by the normal after-tax margin. Note that Value Line's fiscal 2018 EPS estimate of $7.05 for CVS is almost exactly equal to 3.8% (the expected net profit margin) times its revenue projection of $185.30 per share this year.

Companies with less predictable profit margins can drive analysts and traders to drink. Their shares tend to be quite volatile as quarterly earnings surprises, both positive and negative, can be very common.

Francesca's Holdings Corp. FRAN is a good example. From 2011 through 2013 the chain of retail boutiques posted great after-tax margins ranging from 11.5% to 15.9%. From 2014 through 2016 net profit margins dropped to a range of 8.5% to 8.7%. Profitability fell to just 4.0% in fiscal 2017.

Francesca's got clobbered on Sept. 11 after missing on its second-quarter estimate and lowering full-year EPS guidance to a midpoint of $0.20 from $0.56. That reduction implies FRAN's net profit margin will drop to only about 1.4% this year, the lowest ever for this debt-free company.

The stock made an all-time low of $3.53 on Sept. 12 before rebounding slightly. Francesca's closed at $4.06 last Friday, Sept. 14.

Management has taken numerous steps to reverse this trend. A new buyer leading to a more appealing merchandise mix is in progress. Old inventory has been marked down and cleared out. Prospects for a big turnaround are in place. Expect dramatically improved results and a return to more normal profit margins later this year and continuing into fiscal 2019 and beyond.

Consensus views for next year now center on EPS rebounding to $0.65. Value Line thinks Francesca's will be earning around $1.25 per share by 2023 even if net margins are only back to a still-subpar 5.8%.

Francesca's future is much less predictable than the future of CVS Health. If things go well, though, the stock's upside is humongous. Modest operating improvement coupled with a more typical P/E could send Francesca's near $10 before too long. Project out three to five years and $20 to $25 appears reachable.

Keep in mind that traders pushed FRAN to peaks ranging from $18.20 to $37.10 during each of the seven years from 2011 through 2017. The stock hit $8.50 less than two months ago.

It's always tempting to believe the pessimists when a stock has just been taken to the cleaners. Contrarians willing to take the other side of that argument might see outsize gains.

Francesca's has proven earnings power of more than $1 per share. It exceeded that level in fiscal 2012, 2013 and 2016. Revenues are far higher now than ever before. A return to just a mid-range 8.5% net profit margin could produce $1.19 to $1.26 in EPS by next year based on projected sales of $14.85 per share.

With zero debt, no defined pension plan and no preferred shares Francesca's is not going to get into any financial trouble. The retailer is profitable and 2018 almost certainly represents the low point in this cycle.

Think of FRAN, at today's price point, as a perpetual option on an eventual recovery. If the stock reaches $10 you'll have made about 146%. At $15 that rises to 269%. At $20 you'd pocket more than 392% from $4.06.

Unlike owning a call option, there is no time limit on reaching the stated goals.

Conservative investors might want to buy into CVS right now. Speculative types might wish to pick up some FRAN while it's still depressed. I'm betting that both will be fine trades for those with time horizons of at least 12 to 18 months.

(This commentary originally appeared on Real Money Pro on Sept. 17. Click here to learn about this dynamic market information service for active traders and to receive daily columns like this from Paul Price, Bret Jensen and others.)

At the time of publication, Price was long CVS and FRAN shares and short CVS and FRAN puts.