It seems like the investment gurus and so-called experts are always throwing out a new metric for putting an accurate valuation on a company's stock. Some favor price-to-earnings ratios, both forward and trailing. Some use price-to-sales. Investors that follow growth companies or companies that have yet to turn a profit may be inclined to use earnings before interest, taxes, depreciation and amortization (EBITDA). And others seem to love free cash flow as a valuation tool.
All these terms are enough to make the average investor dizzy. Fortunately, there is a way to get a pretty good picture of your stocks' financial health that won't require an advanced degree to figure out: Operating margin. The definition of operating margin is pretty simple. It is the amount of money a company has left over after paying out wages, materials and transportation costs and other expenses that fluctuate from quarter to quarter. The operating margin is then used for expenses that are fixed, meaning the company knows how much cash it needs to pay for these each quarter. Examples would be debt service and dividends.
Calculating a company's operating margin is also fairly easy. Simply take its operating income and divide that figure by its net sales. All of this information is available in company filings and at dozens of places across the Web.
As you may be wondering, a high operating margin is a good thing. For example, if XYZ Inc. has an operating margin of 15% that means the company is making 15 cents for every dollar in revenue and that's a healthy margin.
Let's take a further look at how this metric can help investors build a solid a portfolio.
Don't Be Fooled By Big Revenue Numbers
There are hundreds of companies that report lofty sales figures every quarter, many in the tens of billions of dollars. To the novice investor, this may seem impressive, but dig a little deeper and you may find that XYZ is spending a lot to sell a lot. Say XYZ had fourth-quarter revenue of $1 billion, but its operating margin was only three percent. That means it has only $30 million left over to pay its dividend (if it has one) and reduce its debt. This isn't an impressive figure.
On the other hand, XYZ could've reported an operating margin of 15%, or $150 million, and this figure would likely be cheered by followers of the stock. Of course, operating margins vary among industries and it's important to know what industries are impacted by both high variable and fixed costs.
Take food companies. They are going to be affected by variable costs because they are large purchasers of commodities such as corn, wheat and oats. Commodities price vary constantly and ABC Food Co. may have low variable costs one quarter and high variable costs the next. As a result, its operating income is bound to fluctuate as well. That's why it's important to look at more than just one quarter's worth of operating margin data. Look at several recent quarters for your stock. Then compare its operating margin against those of its competitors. This will give you a more complete picture as to how healthy your stock really is.
Other companies deeply affected by high variable costs include airlines, mining companies, energy providers, oil drillers and explorers and transportation firms such railroad operators and shipping fhedgems.
Comparing Apples to Apples
As we stated earlier, comparing operating margins of various companies is a useful tool for investors, but you'll want to make sure the companies are in the same industry. Let's say ABC and XYZ are the two biggest cereal makers in the U.S. You see their products dominating the cereal aisle at your local grocer and figure one of them might make a good investment.
You also notice that ABC has higher prices and fewer brands available than XYZ, yet ABC's brands seem to be more popular with consumers. As simple as it may sound, this may be a signal that ABC has better control over of its costs and therefore has critical pricing power with consumers. It's also extremely probable that ABC has the better operating margin of the two companies. Essentially ABC's sales come about in a more cost-effective way than its rival's do and that certainly will make for a better investment.
For investors that follow bank stocks, you'll want to learn about the efficiency ratio, which is commonly used in that sector. The efficiency ratio is highly comparable to operating margin in application.
Easy To Use, Great For Your Portfolio
A great place to start applying operating margin may be to run a screen for stocks that have shown rising operating margins over the last three or four quarters. Remember to look for high numbers. If you find a stock that boasts operating margins of 20%, 25% and 30% for the last three quarters, that could make for a great investment.
Don't stop there; remember to look at its competitors. The tipping point may come if you see a similar decline in operating margins at one of your stock's rivals. That could mean your company is eating in into a competitor's market share. If nothing else, it certainly means one company has better costs controls than another and that's where you want to invest.