Understanding the Significance of Operating Margins

A company's operating margin can give investors significant information regarding the value and profitability of a company. The results of this review are an important aspect of a stock analysis. Before making a decision on whether to buy a stock, investors will look at a variety of critical factors that indicate how well a company is currently performing and how profitable it might be in the future. This type of analysis is called fundamental analysis.

In the process of evaluating a company's operating margin, investors will also need to understand operating income, operating expenses, and the difference between fixed and variable costs.

Why Are Operating Margins Important?

Operating income (also known as operating earnings) is revenue less operating expenses for a given period of time, such as a quarter or year. Operating margin is a percentage figure calculated as operating income for some period of time divided by revenue for the same time period.

Operating margin is the percentage of revenue that a company generates that can be used to pay the company's investors (both equity investors and debt investors) and the company's taxes. It is a key measure in analyzing a stock's value. Other things being equal, the higher the operating margin, the better. Using a percentage figure is also very useful for comparing companies against one another or analyzing the operating results of one company over various revenue scenarios.

Fixed and Variable Costs

Revenue can be derived in a number of ways, depending on the type of business. Similarly, operating expenses come from a variety of sources and can be categorized as fixed costs or variable costs. Since operating expenses are a key component of calculating a company's operating margins, it's important to understand how these fixed and variable costs are derived.

Fixed Costs

Analysts often characterize expenses as either "fixed" or "variable" in nature. A fixed cost is a cost that remains relatively steady as business activity and revenue change. A rent expense is an example of this. If a company leases or rents a property, it usually pays a set amount each month or quarter. This amount does not change regardless of whether business is good or bad at the time.

Variable Costs

By contrast, a variable cost is one that changes as business activity changes. One example is the cost of buying raw materials for a manufacturing operation. Manufacturing companies must buy more raw materials when business speeds up; therefore, the cost of buying raw materials increases as revenue increases.

Operating Leverage

Analyzing a company's mix of fixed and variable costs, called a company's operating leverage, is often important in analyzing operating margins and cash flows. When revenue increases, the operating margins of companies that are fixed-cost intensive have the potential to increase at a faster rate than those that are variable-cost intensive (the reverse is also true).

Because equity analysis involves projecting future operating results, understanding the relative importance of fixed costs is vital. Analysts must understand how operating margins will change in the future given certain revenue growth assumptions.

Factoring in the Cost of Goods Sold (COGS)

A special and important form of expense is cost of goods sold (COGS). For companies selling products that they manufacture, add value to, or simply distribute, the cost of goods sold is accounted for using inventory calculations. The basic formula for COGS is:

COGS = BI + P - EI

Where:

• BI is beginning inventory
• P is inventory purchases for the period
• EI is ending inventory

COGS strives to measure the cost of inventory sold in a period; the actual amount incurred to buy inventory might be significantly higher or lower. By netting out the beginning and ending inventory, companies try to measure the cost of the actual volume of product sold during the period.

Revenue less COGS is known as gross profit, which is a key element of operating income. Gross profit measures the amount of profit generated before general overhead costs that cannot be inventoried, such as selling, general, and administrative expenses (SG&A). SG&A costs might include such items as administrative staff salaries or costs for advertising and promotional materials.

Gross profit divided by revenue is a percentage value known as gross margin. Analyzing gross margin is paramount in equity analysis projects because COGS is often the most significant expense element for a company and is found on their income statement. Analysts often look at gross margin when comparing companies or assessing the performance of a single company in a historical context.

Special Considerations

Non-cash expenses

Investors should also understand the difference between cash expenses and non-cash expenses when analyzing operating results. A non-cash expense is an operating expense on the income statement that does not require cash outlay. An example is depreciation expense. According to generally accepted accounting principles (GAAP), when a business buys a long-term asset (such as heavy equipment), the amount spent to buy that asset is not expensed in the same way as rent expense or the cost of raw materials.

Instead, the cost is spread out over the useful life of the equipment, and therefore a small amount of the overall cost is allocated to the income statement over a number of years in the form of depreciation expense, even though no further cash outlay has occurred. Note that non-cash expenses are often allocated to other expense lines in the income statement. A good way to grasp the effect of non-cash expenses is to look carefully at the operating section of the statement of cash flows.

It is largely because of non-cash expenses that operating income differs from operating cash flow. Investors are wise to consider the proportion of operating income that is attributable to non-cash expenses.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

Analysts often calculate earnings before interest, taxes, depreciation, and amortization (EBITDA) to measure cash-based operating income.

Because it excludes non-cash expenses, EBITDA might be better than operating income at measuring the amount of cash flow generated from operations that is available for investors. After all, dividends must be paid from cash, not income. Similar to gross margin and operating margin, analysts use EBITDA to calculate EBITDA margin, and they use this figure to do company comparisons and historical company analyses.

The Bottom Line

In order to properly assess most stocks, investors must grasp the company's ability to generate cash flow from operations. It is therefore vital to understand the concepts of operating income and EBITDA. As with most aspects of financial analysis, numerical comparisons can tell more about a company than the actual financial parameters. By calculating margins, investors can better measure a company's ability to generate operating income in competitive and historical contexts.