How to Think Like Benjamin Graham and Invest Like Warren Buffett

RecognizingSuccess 127

divides net income by total net sales.) The standard way is as
follows:

Operating income

Net sales

There is tremendous variation in profit margins across industries.
Average profit margins in the automotive an dbanking in dustries, for
example, are way lower (often aroun d10%) than they are in the
computer, pharmaceutical, an dfoo din dustries (as high as 40% in
the case of Microsoft). The S&P 500 average profit margin is about
17.5%, right aroun dwhere GE stan ds, while other conglomerates
show margins of aroun d13 to 14%. Again, companies without earn-
ings, such as Amazon.com, have negative profit margins.
Profit margins can be squeezed or expanded, depending in large
measure on whether a business has a special franchise that gives it
market power or competes in a commodity market where branding
and product differentiation are harder. Coke and Pepsi constantly
pursue product differentiation to exploit the possibility of raising
prices without hurting unit volume, with varying degrees of success
in various economic climates.
Amazon.com invests heavily in this kin dof pro duct differentia-
tion, with a state-of-the-art Web site that includes patented features
such as “one-click” an d distinctive formatting. Yet competitors, in-
cluding barnesandnoble.com and buy.com, easily mimic much of this
would-be differentiation, quickly eroding profit margins.
The competition results in constant efforts to innovate an da d-
vance technology, whether in hamburger stands, on-line booksellers,
or the beverage industry. Such innovation tends to hurt rather than
help commodity businesses but benefits franchise businesses enor-
mously. That is why Microsoft so jealously guards the code to its
Windows operating system. It is why GE spends so many advertising
dollars on campaigns such as “We bring good things to life,” in which
it highlights all dozen or so of its businesses without pitching par-
ticular products such as a washing machine or x-ray diagnostic
equipment.
When a company develops a superior production system for a
commodity product (such as oil), the bulk of the savings from that
system goes to consumers rather than to the company. In contrast,
a company that improves branded goods—those on which prices can