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Asked by Anonymous

Updated 2w ago

What are some risks to investing in a high profit margin stock?

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Thaddeus Tan
Thaddeus Tan, Community Lead at Seedly
Level 5. Genius
Updated 2w ago

Hi Anon, interesting question!

TL;DR

  1. What is a high profit margin stock?
  2. Why do people want to invest in a high profit margin stock?
  3. What are the risks involved?

What is a high profit margin stock?

Profit margin = Net profit/revenue expressed as a %.

This value is known as the profit margin. A high profit margin stock simply means that the net profit/revenue is high. Profit margin is used as a reflection of how much can be retained from your revenue and can be an indicator of business performance. A higher profit margin basically means that the business can increase its profit while minimising costs. Generally speaking, the higher this value, the better it is!

Why do people want to invest in a high profit margin stock?

Everyone wants to make money that’s why!

If a company has a high net profit/revenue, it may lead to an increase in dividends handed out and as investors, WHO DOESN’T WANT A HIGHER ROI... RIGHT?

What are the risks involved?

When you invest in a high profit margin stock, the main benefit to take note of is probably that investors would be protected from an unexpected decline in the company’s income- which is a good thing as it is a reflection of business performance (as mentioned above). The better a business performs, the happier the investor should be!

Here’s not to say that by investing in a high profit margin stock, you are invincible to the risks associated with investing in stocks. The risks involved when investing in high profit margins stocks are almost the same as investing in anything at all. Investing in high profit margin stocks does not mean that there are ZERO risks involved. There will be risks but the risks might not be so high due to a high profit margin. By investing in the first place, you choose to take on a certain amount of risk!

Let me now touch on the risks of investing in stocks.

1. Market Risk

Stocks are susceptible to market risks. Due to the volatility of the market, share price fluctuates in a short period of time constantly. All shares are hence subjected to market risks that are affected by factors that are not within an investors’ control.

2. Liquidity Risk

Liquidity refers to how easy a stock can be purchased or sold or even cashed out in the event you want to take advantage of a situation or to prevent or minimize a loss.

3. Inflation Risk

Also known as purchasing power risk. This might lead to a loss in one’s purchasing power because the value of your investments does not keep up with inflation and hence the cash flowing from an investment today willl not be as much as in the future.

Hope this helps!

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You can't judge the risk of a stock just by its profit margin (earnings). The challenge in investing and risk management is the fact that many things are relative, and each has its own unique cause and effects.

Generally, high earnings is a sign that a company is healthy. Earnings growth is another important factor we have to take into consideration.

Think of it this way...

If we are buying a stock now (at this current level of earnings), the current level of earnings has already been priced into its current stock price. Whether you profit from this stock or not depends (to a large extent) on its future earnings growth, which will determine to some extent the future stock price.

But don't just buy based on earnings or earnings growth. Also look at other factors such as its current stock price relative to its earnings (and many other).

High earnings, but super high stock price mean it is still an overvalued stock. And buying an overvalued stock has an arguably higher probability of seeing its stock price head south.

You can start here. But really... There are many other factors to picking a stock and identifying risks. And its difficult to cover everything. I'm just answering based on your question of "high profit margin".

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Ang Han Wei
Ang Han Wei,
Level 2. Rookie
Answered 2w ago

Hi Anonymous, a short answer will be, it is unlikely that high margin stocks come cheap (using traditional valuation methods like P/E, P/B etc).

Buying a stock with high valuation may make one overpay for it. "Overpay" meaning buying it at a price thag even the high margin does not justify. Be careful and DYODD.

Good luck!

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