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Net Profit Margin is defined as the profit per unit of sales. As net profit is calculated after subtracting all the costs associated with doing a business, consistently increasing NPM indicates that a company is doing a lot of activities in its operations to improve the same. For example, when a steel company like Tata Steel goes in for a captive power plant to reduce its power cost, its NPM improves and gives an edge over its competitors in terms of the valuation. NPM is a good indicator of financial management of the company which is one of the key factors of an ever expanding growth company.
Consistent increase in Sales does not necessarily mean that company has to perform well. For example, assume two companies one with a NPM of 5% and other with a NPM of 20%. Let us assume both these companies are planning to expand their operations which is expected to increase their sales revenue by 20% CAGR over next three years. Now if you observe the market reaction, the share price of the company with NPM of 20% would have immediately shot up by around 5-10% whereas the share price of the company with a low NPM will not increase much. The reason is, because as a shareholder of low NPM company, I’m very much skeptical about the profitability that will be attained through this expansion. I will ask myself what if this new business operation runs into loss. Whereas since I’m already comfortable with high NPM company, I immediately pounce onto that particular share.
Bottom Line: Pick a company with confidence, if it has good NPM (more than 15%). Place bigger faith if such a company has been increasing its NPM over years.