Looking at the income statement of a company will give you a good idea of the earning power of the company or how much profit it can expect in a stable environment. Margins are also important, and for different companies, different margins matter — for some it's gross margin, and for some it's operating margin. The sustainable operating margins of the company are its operating margin profile.
Operating Margin Profile
The operating margin of a company is, put simply, its income before interest and taxes. Operating margin includes such items as sales; cost of goods sold; research and development expense; selling, general and administrative expense; and depreciation and amortization. It is usually talked about on a percentage basis. You can find this percentage by dividing a company's operating margin by the sales number. The higher the operating margin, the better the company's operating margin profile.
The benefit of looking at a company on an operating margin basis is being able to remove the effects of interest and taxes. The amount of debt and interest payments a company has can skew net income and taxes because interest is tax deductible. Net income and taxes can also be skewed if a company has a big cash balance and earns a lot of interest. Looking just at operating margin removes the effects of non-operating items. It also makes it easier to compare companies with different debt, cash and interest levels.
Focusing exclusively on operating margin may lead you to miss the other key parts of the income statement and other financial statements. It will not tell you how much cash the company is generating, whether the company has a strong financial position, or if the company has a lot debt. Missing those items may cause you to miss the fact that the company is in financial distress. The important thing is to not just focus on one item. Although the operating margin profile of the company may be important, you have to scrutinize all of the information a company puts out to get a better feel of the company.
Other Valuation Tools
While you want a company's operating margin profile to be strong, it is also important to recognize how much you are paying for each dollar of cash flow or earnings. The company is worth the present value of its cash flows, so it is important to keep all of the metrics in perspective. If the operating margin profile of a company is becoming stronger, that's great, but ultimately it has to show up on the cash flow statement.
Alex Shadunsky has a bachelor's degree in finance and is pursuing a Master of Business Administration from Indiana University. He has worked at Briefing.com as a junior equity analyst specializing in health-care stocks.