Understanding Operating Income and Profit Margin

A Guide for New Investors

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Operating income, also called operating profit, represents the total pre-tax profit a business has generated from its operations. Investors and analysts often use operating profit information to assess the desirability of companies as investment candidates. For a business like Papa John's Pizza, for example, it represents the pre-tax profit the company generates from selling pizzas.

The operating income shows, in terms of dollars, what remains for the owners after deducting all of the expenses related to producing the pizzas and operating the business.

The profit margin represents a view, in percentage terms, of the operating income left after all expenses have been deducted. This simplifies comparing profit margins of different companies. A large company might have what looks like a significant amount of operating profits, but if it's operating costs are high, it may have a low profit margin.

Gauging a Company's Operational Performance

Operating income can be used to gauge the general health of a company's core business or businesses. Profits are one of the most important figures to review when considering an ownership stake in a business through the purchase of common stock or lending your money to a business through an investment in its corporate bonds.

Unless a firm has a lot of assets it can sell, any money that it pays out to shareholders as dividends must be generated by selling a product or service. If a company experiences declining operating income, it has less money for owners, expansion, debt reduction, or anything else management hopes to achieve.

Lenders and shareholders tend to watch operating profit closely. This can present certain challenges, as some businesses have operating incomes that fluctuate wildly with economic conditions.

These types of firms are known as cyclical companies. They consist of businesses like steel mills, aluminum manufacturers, automobile manufacturers, heavy equipment manufacturers, hotels and resorts, home builders, and many luxury item manufacturers, such as fine jewelry companies.

These enterprises may still make a good deal of money, but they won't have a smooth, upward trend in operating income because the business will likely contract during recessions and depressions.

When gauging the value of cyclical companies, a single year of operating profit in isolation won't tell you what you need to know, so work with at least two or three years of historical data before drawing your conclusions.

Operating Income 

Gross profit results from subtracting a company's cost of goods from its gross revenue. Below gross profit on an income statement, you'll find the firm's operating expenses. These include compensation-related expenses, sales and marketing costs, and miscellaneous office expenses like utilities and office supplies.

Use the following formula to calculate operating income with inputs from the income statement:

Gross ProfitOperating Expenses = Operating Income

Calculating the Operating Margin

To calculate the operating margin, divide your operating income result from above by total revenue.

Operating Income / Sales = Operating Margin

Whether the percentage result qualifies as a good operating margin depends on the industry. However, you can get a frame of reference by comparing a company's operating profit margin to the S&P 500. If your target company's profit margin exceeds the S&P 500's return, you have found a company that is beating the market.

Interpreting the Results

Companies review their operating margin, or operating profit margin, as a measurement of management efficiency. The profit margin calculation provides a result that helps compare the quality of a company’s financial activity to its competitors.

A business with a higher operating margin than other firms in its industry generally has better performance, as long as the gains didn't come from taking on large amounts of debt or by taking speculative risks with shareholders' money.

The most common reason companies experience high operating margins relative to their competitors stems from a low-cost operating model. This is when the company has found a way to deliver merchandise or services to customers at much cheaper prices than its competitors and still make a profit.

A classic example is Wal-Mart, which can get everything from toothpaste to socks into its stores at far lower prices than the competition due to the efficiency of its warehouse distribution system.