Investing Series: What are operating margins and why do I care?

This is a part of the Investing Series.

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OPERATING MARGINS ARE A LOT LIKE PROFIT MARGINS IN THEORY

Just a different way of looking at making money.

The one major difference between profit and operating margins are that profit margins look at how much is leftover as a percentage of the income, but operating margins, look at how much money is available to pay for things like the factory, utilities, interest on their long-term debt, and all of those other fixed costs. 

• Read: All about Profit Margins

So basically you want to know how much money they’re using each year to run the business with operating margins, and then when you look at net profit margins, how much out of THAT operating margin becomes retained earnings or savings.

HOW TO CALCULATE NET OPERATING MARGINS

EBIT / Sales

EBIT = Earnings before income taxes

See how it’s quite similar to profit margins where they look at Net Income / Revenue or Sales?

It’s just a different way of looking at how the money is used and made for every $1 in sales.

So if a company has an “operating margin” of 30%, it means that they make $0.30 in every $1 they sell.

WHY IS A HIGHER OPERATING MARGIN GOOD?

(A higher profit margin is good too!)

If operating margins increased every year for a company, it means that they’re getting better and better at using every dollar they have in sales to keep their business running as a lean mean, money making machine.

(This is also similar to a profit margin because if you lower your costs, your profit margins go higher, but it is just a more nuanced look at the same idea.)

It also means that they have money left over (presumably) to be able to weather through economic storms and stay the course as they are essentially able to keep costs down in their overhead (factory, utilities, labour), while keeping as much of that earned dollar as possible.

Again, back to the analogy of a household budget!

It’s like deciding to rent a place at $500 a month instead of $1500 a month, because you’re sacrificing amenities like a pool and a gym at your apartment building.

Maybe you end up in this shack instead:

You will get an additional $1000 in your pocket each month, just by giving up those ‘luxuries’.

Your operating margin increased by $1000, which also means you could just save the money and increase your profit margin as well by $1000.

Or you could just spend more money on food and buy fancy things to eat like cheese, which would decrease your margins but improve your quality of life:

Whereas in contrast a high profit margin as you learned last week, may just signify that the company has an advantage over the others in their industry.

Case in point:

APPLES VERSUS ….. LEMONS? 

Using my favourite topic: laptops, Apple for instance, makes their money on their hardware not their software.

Their laptops are marked up by a healthy profit margin, but they don’t screw you on the software upgrades and “fixes”, and their laptops last a good, long life if you take care of them.

Other laptops like Dell, Toshiba and so on, run on Windows operating systems, and although their laptops are cheap plastic pieces of crap (no, I am NOT biased AT ALL.. 😛 ) they sell well because they’re at affordable price points for people.

Where these cheap plastic laptop companies screw you, is that the plastic laptop dies after 3 years and has to be replaced, but the Apple laptop lasts at least 3X as long.

Or they screw you because you have to upgrade Windows, or the RAM, or all those other things that make it so your computer which after a year is considered “an ancient outdated piece of crap”, can run the newest Windows PC programs today.

Cost per use comes into play here, but that’s another post for another day.

SUMMARY

• Operating margins are a lot like profit margins in theory
• Operating margins look at the way the company uses a dollar in sales in running their business
• ..whereas profit margins just look at how much they save each year
• You have to compare margins between rivals in the industry to see the benchmarks