Outside the Box: The Importance of Expanding Operating Margins

Operating margins, also known as profit margins, are very important for the fundamental analyst to understand. Operating margins represent a company’s operating income divided by net sales. This figure is an important to analyze because it is difficult to manipulate under generally accepted accounting principles and provides a much clearer view of how a company is doing than other figures will.

If a company’s operating margin is expanding each year and quarter over quarter, it shows that they are making money on every dollar of revenue they collect on the goods or services that they sell. For instance, you can sometimes find companies with huge sales growth but have poor operating margins.

In this case a company more than likely lowered prices to generates sales, which is tremendous for the top line but certainly isn’t a reflection of consistent growth. Also, there are cases in the services industry that may show top-line sales, but profits may be wiped out by adding new people as well as additional marketing costs.

As a fundamental analyst it is very important to keep in mind that margins may show a strong but temporary spike for several reasons. First, a company may adopt cost controls and reduce expenses so each dollar of sales is bringing more to the bottom line. It is certainly nice to see that the corporation is responsible with their finances but do understand that this is not a sustainable source of growth.

For example, in the retail sector you will often encounter margins that spike when low-sales stores are closed. Again, it’s good to see management take the necessary steps to improve the bottom line, but closing stores is not really a way to promote company growth. Another way in which operating margins expand is where a company sells more of its product however the basic costs of the business do not go up.

All that being said, margin improvement is a very strong fundamental factor. Companies that can expand the amount of money on each and every dollar in the door are more often than not extremely successful stock investments. This is why when analyzing fundamentals a close eye needs to be focused on operating margins. Increasing margins typically indicates that a company is dominating its business space or has a new product or service.

When a stock has been identified that has healthy operating margins be sure to watch for the inevitable erosion. There are a variety of reasons profit margins can stop expanding and none of them are good. For instance, there may be excessive overhead as management gets too complacent enjoying its past success. Margins can also shrink when regulations are increased in a particular industry. Recent examples of this include both the utilities and pharmaceuticals industries.

The point to remember here is that operating margins are a very important fundamental variable. Typically, if a company’s margins expand, it will be a powerful force that leads to an ever increasing and explosive stock price.

Happy Trading.

Jeff Neal 
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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