Operating profit margins and its importance in investing in shares

Operating profit margins and its importance in investing in shares

Introduction 

Operating profit margin (OPM) is derived when direct expenses are reduced from total sales. OPM in excess of 10-12% is considered to be good. Higher the OPM the better. In business environment lot of factors keep on changing in real-time which affects the margin of the business. If a company has higher OPM it will be able to withstand and sustain adversity due to change in business environment. Regulatory changes, demand-supply changes , currency fluctuations, commodity cycles, change in rate of interest etc. are some of the changes that can affect a business.

Business with very low operating margins shall be altogether avoided. Because even a slight change in business environment can hamper the growth of business negatively impacting shareholders value. To improve operating profit margin companies can focus on cost reduction steps or increase sales of products which have high margins by changing the sales-mix of products.

Operating Margin (%) = Operating Profit / Net Sales

Operating Margin Important points : 

• Businesses which are having high competition or which are approaching end of life cycle are likely to have lower operating profits and should be avoided. Eg. Wires Business or Computer hardware business

• Businesses which have monopoly or very high market share in a sector or some form of competitive advantage which cannot be easily replicated will normally have higher operating margins and shall be good for investment objective Eg. Alcohol industry due to barriers on entry of new players or Any Government enterprise having monopoly in a sector

• Operating margins of a sector can be altered substantially due to change in business environment which can make a new investment advisable or an old investment obsolete. Eg. Demand for Automobiles is slowing down due to rise of cab industry and is likely to go down further in future. So investment in auto sector may not likely be advisable.

• While evaluating an investment in shares, one has to ensure whether there is consistency in operating profit margins for a certain period of time to say like 3 or 5 years. Companies which have very volatile operating margins can have wild share price fluctuations regularly is unlikely to delivery good returns to shareholders

• To improve operating profit margins, company can eliminate or outsource products with low profit margins. Increasing proportion of products with higher margins or introducing newer products with higher margins can also help

• Cost-reduction program can be undertaken to improve operating profit margins. Reduction of cost can be done in various domains like packaging, transportation, raw material procurement, automation to replace costly labor etc.

• Operating profit margin of companies with similar size and similar business model can be compared to identify which one is efficient