The Operating Margin ratio explained.

The operating margin is a “profitability ratio” also known as the EBIT Margin or Return on Sales. The ratio measures the revenue after deducting the operating expenses associated with generating that sale to show how much profit a business makes on a dollar of sales. It excludes Interest and tax expenses.

Operating income is interchangeable with EBIT (earnings before interest and tax), which is why the EBIT margin is also referred to as the operating margin.

A high margin is preferred over lower margins. A higher margin means that the company is generating more profits from operating to cover its fixed and variable costs. Sustainable and growing operating margins show that a business is becoming more efficient with its resources at earning profits.

A declining margin can be due to misallocation of capital, loss of market share a weakening competitive edge, and in general lack of efficiency from the management team.

The operating margin is a good way to see how effective a business is operating and how good it is at turning sales into profits. High margins mean turning more sales into profits!

I like using this ratio as it is directly related to the company’s core business operations and excludes other areas of income like investments it has made (although it can be an imperfect ratio). This is important when it comes to profits from core business activities which is why we use “core expenses” to determine our ratio.

What is the Operating Margin formula?

• Operating Margin = Operating Income (EBIT) ÷ Revenue
• Operating Income = Found on the Income Statement and is the EBIT (Earnings Before Interest and Tax)
• Revenue = Found on the Income statement.

The operating income takes the gross income, which is total revenue minus COGS, and subtracts all operating expenses.

How to use the OM ratio?

The first and most common way to use the operating margin is to look at a company you are researching and take the past few years and determine if a) is operating margin growing or b) is it declining. Then we want to understand what is contributing to the changes. If it is growing it means a company is performing better, management is becoming more efficient with resources, improving its pricing model, and perhaps growing its competitive advantage.

So for our first example let us examine Company A and extract its operating margin over 2 years.

Income Statement	2022	2023
Revenue	$129.34 million	$142.41 million
– (COGS)	($50.4) million	($51.5) million
Gross Profit	$78.94 million	$90.91 million
Salaries	($7.5) million	($7.6) million
General & Administration	($11.1) million	($11.3) million
Rent & Overheads	($1.3) million	($1.5) million
Operating Income (EBIT)	$59.04 million	$70.51 million
Operating Margin %	45.64%	49.51%

2022 ($59.04 ÷ $129.34) x 100 = 45.64%

2023 ($70.51 ÷ $142.41) x 100 = 49.51%

In this overly simplified example, we can look at the financial statements of this company and see the change in revenue, the change in operating expenses, COGS, and the flow through to an increase in operating margin. If we were to take this business and go back 3-5 years and see this slight upward trend we can see it is consistently improving its operations.

What does this percentage mean? It means that with an operating margin of 49.51%, for every dollar of sales generated, 0.49 cents is retained as operating profits.

The same ideology exists if the operating margin is declining, we can explore further to understand if the business operations are becoming inefficient, or perhaps losing market share. Sometimes cyclical businesses can have vastly different margins based on the cycle.

In another example below, let’s compare 3 companies in the same industry to determine which one has the higher operating margin.

Income Statement	Company A	Company B	Company C
Revenue	$1.2 billion	$2.5 billion	$1.9 billion
– (COGS)	($550) million	($1.5) billion	($1.1) billion
Gross Profit	$650 million	$1 billion	$800 million
Operating Expenses	($120) million	($380) million	($275) million
Operating Income	$530 million	$620 million	$525 million
Operating Margin %	44.16%	24.8%	27.63%

Company A ($530m ÷ $1.2b) x 100 = 44.16%

Company B ($620m ÷ $2.5b) x 100 = 24.8%

Company C ($525m ÷ $1.9b) x 100 = 27.63%

In this case if the industry benchmark had an operating margin of 26% Company B and Company C are within that average, however Company A is clearly a lot more efficient and retaining 0.44 cents from every dollar of sales.

When comparing investment ideas and finding this type of discrepancy from one company to the next, it can prompt us to find out what is causing the company to outperform, especially if the company is above the industry benchmark and its peers. Hello MOAT?

When generating investment ideas I would start with a company comparison against its competitors, if a company stands out then dig into its financials and follow the last few years to see how it has performed.

What are some of the drawbacks of using the OM?

The ratio excludes noncash items like D&A and stock-based compensation. It also excludes capital expenditures (Capex) which is a very important part of the financial statement. When we evaluate companies side by side sometimes the operating margin will be the same but still one company will be a better performer because of how it funds itself and the other areas that come after EBIT.

Operating margin includes only operating costs but excludes any non-operating costs. This can draw some criticism.

What if the margin is negative?

Move to another business. Sometimes a business can have down quarters but typically the business model is not sustainable if the operating margin is negative. It requires funding if it drags out. The operating margin is the first part of the income statement and if a company has a negative OM it would indicate the cost of sales or operating expenses exceed sales (spending more money than you’re making).

In Summary…

High operating margin is what you are looking for no matter the industry Value or Growth. A higher operating margin means more can flow through to the bottom line, a business can cover its fixed and variable costs and sustain down markets. It can also be viewed as a contributor to the risk of the business.

Every industry must be compared to its peers. Software companies can have operating margins of 80% whilst retail may have 20% margins. If an investor is focused on a percentage-only filter a higher operating margin is going to lead towards those industries that boast them like technology or healthcare and away from oil and gas and low-margin sectors.

Investors should closely watch the operating margin along with the Operating Leverage to assess the trend of how a company is becoming more efficient over time. It is directly related to the core business and that is why I value using this ratio.