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Operating margin: how profitable the business really is

Definition of operating margin, its formula, where to find operating profit in an annual report, usual levels by sector and by profile, and the traps of reading it.

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Definition

Operating margin divides operating profit by revenue. It shows what share of each euro billed stays with the company once all the costs of its business have been paid: production, salaries, marketing, research, overheads, depreciation. It is read before financial costs and tax, which makes it possible to compare companies with more or less debt.

Formula

Operating margin = operating profit / revenue

Where to find it in an annual report

Income statement: operating profit comes after operating expenses, revenue is at the top. Many companies also publish recurring operating profit, excluding one-off items, which is more useful for tracking the change from one year to the next.

Common thresholds

Long-term quality: 20% or more for green, 10 to 20% for orange. Differences between sectors are large: a mature software company often exceeds 25%, a manufacturer is around 8 to 15%, a food retailer around 3 to 5%. Compare a company with its direct competitors and its own past.

In the preset strategies

Preset strategy Criterion met To monitor Criterion not met
Long-term quality Operating margin ≥ 20% 10% to 20% < 10%

Pitfalls

  • One-off items (impairments, restructuring, gains on disposals) distort a year: use recurring operating profit when there is one.
  • The adjusted operating profit some companies highlight sometimes leaves out recurring costs, such as stock-based pay: check what is excluded.
  • A rising margin can come from cuts in research or marketing spending, which will weigh on growth later.
  • A low margin is not a flaw in itself in a high-volume sector with little capital spending.

Where it does not apply

  • Banks and insurers: their income statement does not show a comparable operating profit.
  • Investment companies and conglomerates whose earnings come mainly from their stakes in other companies.

A worked example

A fictitious company, called Company Q here, generates €400 million of revenue and recurring operating profit of €88 million. Its operating margin is 88 / 400 = 22%: green for the Long-term quality preset strategy.

From gross margin to operating margin

Gross margin only removes the direct cost of products. Operating margin also removes sales, administrative and research expenses. A company can have a very good gross margin and a weak operating margin if its overheads are expensive. Following both over several years shows where profitability is created.

Sources