The financial ratio that professional investors focus on more than any other is operating margin, or operating income ÷ revenue.
The major categories of expenses subtracted from revenue to get to operating income are: direct costs of creating a product/service (cost of materials, wages, power, water…) plus depreciation and SG&A (sales, general and administrative) expenses. SG&A includes things like the cost of top management, sales force and corporate headquarters.
the higher, the better?
Most people assume that the higher the operating margin is, the more attractive a company is as an investment. The idea is that the company in question must have spectacular offerings to be able to charge high prices that exceed the cost of creating them by a lot. But that’s only true in very specific circumstances.
value and sustainability
The two big questions are whether current high margins are valuable and whether they are sustainable.
The first point sounds weird but is actually an important special case. Some companies (think: fine jewelry or furniture) have high margins–high profits on each sale–because to do business they have to maintain large inventories that don’t turn over very frequently. Unlike candy in the checkout aisle, where the starting inventory may be sold several times a day, it may take six months or longer to sell a brooch or a sofa that’s on the showroom floor. So, yes, the margins are high. But a good part of that is to compensate for the expense of holding inventory (not such a concern in a 0% interest rate world) and the risk that items may go out of style (or never have been in style) before they’re sold.
Most of the time, however, sustainability is the key issue. That’s because high margins draw competition. Personally, I think very high margins are never sustainable forever. So for me the question is how quickly, and how publicly, they’ll be eroded. I’m willing to believe that there’s an enduring value to intellectual property like patents. So I’m happy to buy tech companies. There’s also a value to intangibles, like a strong brand name, an efficient distribution network and good customer service. However, intangibles are not the no-brainer it used to be. The internet has eroded that value badly from what it was twenty years ago–much to the consternation of people like Warren Buffett, whose career was built on his superior understanding of intangibles.
In any event, the holder of high-margin firms has to be alert to possible threats to the franchise. Often the threat comes in the form of what are initially thought to be inferior products. The $3000 PC replaced the $100,000 mini-computer, not because the former was better than the latter but because you could get 30 of them and make do for less than a single machine from DEC. Same thing with mp3 players vs. stereos. The sound is inferior but the machines are cheaper and portable.
the beauty of low margins
Again, personally, I find myself attracted to distribution companies, which have high operating income despite low operating income margins, because they have high inventory turnover. The ones I find most compelling send to sell a product long before they have to pay their supplier for it. Also, they’re badly understood by devotees of high margins.
A final note: value investors begin to salivate when they find a firm with much lower margins than is the norm for the industry. Typically, the stock will be very cheap and, they believe, it’s just a matter of time before either the board of directors takes corrective action or the company is taken over. Normally not my cup of tea but I’ll dabble on occasion.