Lesson 3.1 · 1 of 5 · The quality of a business
Profit margins explained: what they show, with Costco and Microsoft
Profit margins show how much of each dollar of sales a company keeps at each stage: after the cost of what it sells, after running costs and at the very end. They mean most next to similar companies and over several years: a retailer on 4% can be every bit as well run as a software company on 45%.
Terms in this lesson
- Gross margin
- What is left of sales after the direct cost of the products.
- Operating margin
- How much operating profit is left from every $100 of sales.
- Net margin
- How many dollars of profit are left from every $100 of sales.
- Free cash flow (FCF)
- The cash left to the company after it pays for its investments.
Gross, operating, net and free cash flow margins
In the lesson on the income statement you worked out Apple’s margins. Here you put them side by side for two businesses that could hardly be more different: a membership warehouse club and a software company. Each margin answers a different question.
| Margin | What it shows | Costco | Microsoft |
|---|---|---|---|
| Gross | what is left after the cost of the goods | 11.1% | 67.9% |
| Operating | what is left after running costs | 3.8% | 46.8% |
| Net | what is left after interest and tax | 2.9% | 40.3% |
| Free cash flow | what is left after investment | 2.8% | 20.2% |
Costco: financial year ended 31 August 2025, revenue $275,235 million; the gross margin is shown the way the company presents it, on net merchandise sales ($269,912m - $239,886m). Microsoft: financial year ended 30 June 2026, revenue $331,839 million. Figures from the Form 10-K annual reports.
Definition
What is the free cash flow margin?
Free cash flow divided by revenue.
Free cash flow is operating cash flow minus the money spent on buildings and equipment. Its margin shows how much cash is really left from each dollar of sales once investment is paid for. At Microsoft in financial year 2026: $182,935m - $115,948m = $66,987m, or 20.2% of revenue, well below the 40.3% net margin. The gap comes from heavy spending on data centres. The net margin was also helped by $10.7 billion of net “other income”, mostly gains on investments, including its stake in OpenAI.
Microsoft, financial year 2026.
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Create a free accountWhy you compare margins only within the same sector
Next to Microsoft, Costco looks like a weak business. Next to a direct competitor, the picture changes. Walmart also sells goods in large volumes and runs its own membership club, Sam’s Club.
| Measure | Costco 2025 | Walmart 2026 |
|---|---|---|
| Revenue | $275.2bn | $713.2bn |
| Gross margin on merchandise | 11.1% | 24.2% |
| Running costs, % of revenue | 9.1% | 20.7% |
| Membership fees | $5.3bn | $6.8bn (with other income) |
| Operating margin | 3.8% | 4.2% |
Costco: financial year ended 31 August 2025. Walmart: financial year ended 31 January 2026. Gross margin on merchandise = (net sales - cost of goods) ÷ net sales. Running costs = selling, general and administrative expenses. Figures from the Form 10-K annual reports.
Example
How do they end up with similar operating margins?
By different routes: Costco sells close to cost, Walmart marks up more but spends more.
Costco keeps only 11.1% of merchandise sales above their cost, carries a limited range of products in large warehouses and has running costs of 9.1% of revenue. At Walmart the figure is 24.2%, but it has thousands of stores, far more staff and running costs of 20.7% of revenue. In the end the operating margins are close: 3.8% and 4.2%. That is why you compare companies with the same kind of business, and look at every stage, not just one.
How to read the trend in margins over time
Columns showing Microsoft’s operating margin for financial years 2017-2026, ending on 30 June: 30.1%, 31.8%, 34.1%, 37.0%, 41.6%, 42.1%, 41.8%, 44.6%, 45.6% and 46.8%. The margin rises almost every year; the only small dip is in 2023.
Over ten financial years Microsoft’s revenue rose 3.4 times, from $96.6bn to $331.8bn, and its operating income 5.3 times, from $29.0bn to $155.2bn. When costs grow more slowly than sales, the margin rises. The reverse, a margin falling year after year while sales grow, usually points to more competition, lower prices or costs getting out of hand.
Real case
Microsoft: the operating margin rises, free cash flow does not
Between financial years 2024 and 2026 the operating margin rose from 44.6% to 46.8%. Over the same period the free cash flow margin fell from 30.2% to 20.2%, because spending on buildings and equipment climbed from $44.5bn to $115.9bn a year. Operating income does not deduct that spending straight away: it spreads it over many years through depreciation.
Lessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: Costco, Form 10-K for the financial year ended 31 August 2025 (revenue $275,235m, net sales $269,912m, membership fees $5,323m, merchandise costs $239,886m, selling, general and administrative expenses $24,966m, operating income $10,383m, net income $8,099m, operating cash flow $13,335m, spending on property and equipment $5,498m); Walmart, Form 10-K for the financial year ended 31 January 2026 (revenue $713,163m, net sales $706,413m, membership and other income $6,750m, cost of sales $535,395m, operating, selling, general and administrative expenses $147,943m, operating income $29,825m); Microsoft, Form 10-K annual reports for financial years 2018, 2020, 2023 and 2026 (revenue and operating income for financial years 2017-2026, with 2017 as restated in the 2018 report under the new revenue recognition standard; for 2026: gross margin $225,465m, net income $133,749m, net other income $10,697m, including net gains on investments of $4,385m, operating cash flow $182,935m, additions to property and equipment $115,948m; for 2024 and 2025: operating cash flow $118,548m and $136,162m, additions $44,477m and $64,551m); Apple, Form 10-K for financial year 2025 (net sales $416,161m, operating income $133,050m).