If you speak to most investors, they’ll tell you that the fundamentals matter. The price of a stock can only tell you so much. Is the company growing its revenues? Is its EPS rising? How about its operating margin, is it consistently improving?
Analysts are paid big bucks to investigate these numbers and make future projections.
What Is Operating Margin?
It measures how much profit a firm makes on a dollar of sales, after costs of goods sold and all operating expenses, not including interest or taxes. The operating margin is also called (EBIT) earnings before interest and taxes.
Operating Profit is the subtotal on the income statement, excluding non-operating income, taxes, and interest expenses. The operating expenses include selling, general, administrative, depreciation, amortization, and any other operating expenses.
Operating Profit = Gross Profit – Operating Expenses
The best way to calculate the operating profit margin is to use the income statement. It’s achieved by dividing the operating income by total revenue, then multiply by 100 to express it in percentage terms.
Operating Profit Margin = (Operating Profit ÷ Revenue) × 100
(Gross Profit / Revenue) x 100 = Gross Margin
-Selling, general, & admin. expenses
-Other operating expenses
(Operating Profit / Revenue) x 100 = Operating Margin
Let’s look at an example of Exxon Mobil (NYSE: XOM):
For the year 2017, Exxon had total revenue of $237,162,000 and an operating income of $12,074,000. That said, its operating margin for the period was 5.09%
In the example, Exxon makes $0.059 before interest and taxes for every dollar of sales.
Is that good?
As with most numbers in finance, it’s all relative. That said, you’ll have to compare it to its industry peers.
A rookie mistake is comparing apples to oranges. As you can see below, some sectors are more profitable than others.
source: CSI Market
Why Operating Margin Matters
Operating margin tells us how efficient a company is at its core business. Generally, the more profitable a company is, the better its stock price will perform.
Amazon.com is an exception to the rule.
Amazon.com, one of the best-performing stocks over the last decade, has struggled to increase its operating margin. On the other hand, having a high operating margin doesn’t always mean that the stock will be a top performer.
Operating margin is one way to measure a company’s profitability. The way it changes (in % terms) over time can give an accurate picture of how efficient a company is running different parts of its business.
That said, consider adding other fundamental indicators in your analysis, such as revenue growth, P/E ratio, net profit margin, and EPS to name a few.
Now, if you’re a day trader, you probably aren’t overly concerned on what a stock’s operating margin is. Instead, your focus is on price action or some news catalyst. But for a long-term investor, monitoring the EBIT.
Now, if you remove depreciation and amortization from the EBIT, it deletes all non-cash expenses from operating income. That said, analysts prefer earnings before interest, taxes, depreciation, and amortization (EBITDA) over EBIT because it gives a more accurate reading of operating profitability.