Analyzing operating margins
Understanding the Meaning of Operating Margins
A company's operating margin can provide investors with useful information about a company's value and profitability. The results of this review are an important aspect of stock analysis. Before deciding whether or not to buy a stock, investors will consider several critical factors that indicate a company's current performance and future profitability. 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 revenue, operating expenses, and the difference between fixed and variable costs.
Why are operating margins important?
Operating income (also known as operating income) is income minus operating expenses for a specified period, such as a quarter or a year. Operating margin is a percentage calculated as operating profit for a certain period divided by revenue for the same period.
To make an accurate comparison of companies, operating margins should only be used to compare companies that operate in the same industry and have similar business models.
Operating margin is the percentage of revenue generated by a company that can be used to pay the company’s investors (both equity investors and debt investors) and corporate taxes. It is a key measure in analyzing the value of a stock. All other things being equal, the higher the operating margin, the better. Using a percentage is also very useful for comparing companies with each other or analyzing a company’s operating results under different revenue scenarios.
MAIN POINTS
An operating margin is an important measure of the profit made by a company after deducting the variable costs of production, such as raw materials or wages.
A business needs a healthy operating margin to pay its fixed costs, such as interest on debt or taxes.
A high operating margin is a good indicator of a well-run business and is potentially less risky than a business with a lower operating margin.
In addition to looking at operating margins, investors who perform fundamental analysis of stock also evaluate other key metrics, such as cost of sales (COG), non-cash expenses, and profit before interest, taxes, and amortization (EBITDA)
Fixed and Variable Costs
Revenue may be derived in some ways, relying on the kind of enterprise. Similarly, running costs come from a whole lot of assets and may be classified as constant charges or variable charges. Since running costs are a key factor in calculating an enterprise's running margins, it is crucial to recognize how those constant and variable charges are derived.
Fixed Costs
Analysts frequently symbolize costs as either “constant” or “variable” in nature. A constant fee is a fee that stays rather consistent as enterprise pastime and sales alternate. A lease price is an instance of this. If an enterprise rental or rents a property, it typically can pay a fixed quantity every month or quarter. This quantity does now no longer alternate no matter whether or not the enterprise is right or horrific at the time.
Variable Costs
By contrast, a variable fee is one that adjustments as enterprise pastime adjustments. One instance is the fee for purchasing uncooked substances for a production operation. Manufacturing groups should purchase greater uncooked substances while the enterprise speeds up; therefore, the fee for purchasing uncooked substances will increase as sales will increase.
Operating Leverage
The analysis of a company’s combination of fixed and variable costs called a company’s operating leverage, is often important in the analysis of operating margins and cash flow. When revenues increase, the operating margins of fixed-cost-intensive firms may grow faster than variable-cost-intensive ones (the reverse is also true).
Since equity analysis involves projecting future operating results, it is essential to understand the relative importance of fixed costs. Analysts need to understand how operating margins will evolve in the future given certain revenue growth assumptions.
Special Considerations
Noncash Expenses Investors should also understand the difference between cash and noncash expenses when analyzing operating results. A non-cash expense is an operating expense on the income statement that does not require an outflow. An example is depreciation expense. According to generally accepted accounting principles (GAAP), when a company buys long-term activity (such as heavy equipment), the amount spent on buying this activity is not responsible in the same way as rental costs
