What is operating margin and how is it interpreted in a company?

Operating margin sits one step below gross margin in the profitability cascade and answers a more complete question: out of every euro of sales, how much is left for the company after paying all the costs of operating the business? Not just the direct cost of producing (which the gross margin already subtracted), but also the operating expenses: the sales team, marketing, administration, R&D and depreciation. What's left after all that is the operating profit or EBIT (earnings before interest and taxes), and as a percentage of sales it's the operating margin.

Its great virtue is that it isolates the profitability of the pure business, without it being contaminated by how it finances itself or by taxation. Interest depends on how much debt the company has (a financial decision, not an operating one) and taxes depend on the country and one-off items. By measuring profit before those two things, the operating margin tells you how good the business is in itself, which makes it ideal for comparing companies with very different debt structures: two companies with the same business but one heavily indebted and the other debt-free will have different net margins, but their operating margins are comparable.

That's why operating margin is probably the margin most used by analysts to judge the quality of a business. A high operating margin means the company controls both its production costs and its expense structure well, and that it has enough pricing power for money to be left over after paying everything needed to operate. An operating margin that stays high for years, compared with its sector, is one of the most reliable signs that there's a moat or competitive advantage behind it.

Like all margins, it only makes sense compared with its sector and with its own history. Software and some pharmaceuticals reach operating margins of 30-40% or more. Branded consumer goods usually move in the 15-25% range. Industry and automotive run around 5-12%. Distribution and retail work with thin operating margins of 2-6%, because their model is one of volume. An operating margin of 10% can be excellent in a supermarket and mediocre in a tech company: the benchmark is always the sector.

The trend of the operating margin is enormously informative because it captures two effects at once: what happens with the gross margin (prices and production costs) and what happens with the expense structure (operating efficiency). An operating margin that improves while the company grows is the sign of so-called operating leverage: sales rise faster than fixed costs, so each new euro of sales leaves more profit. An operating margin that deteriorates warns of competition, of costs spiraling, or of a company growing by spending ever more on marketing.

It's worth relating it to the rest of the cascade and to the balance sheet. The operating margin sits between the gross margin (above) and the net margin (below). Comparing gross and operating margins tells you how much the expense structure eats up; comparing operating and net tells you how much debt and taxes weigh. Moreover, EBIT (the numerator of the operating margin) is the basis of the profitability metric par excellence, ROIC, which relates that operating profit to the capital invested to generate it. A high operating margin usually comes accompanied by a high ROIC.

In DeepTicker, the operating margin and its evolution are a central part of the quality signals that feed the DeepScore, the 0-100 score based on the analysis of quality and competitive advantage (moat). The Profitability dimension values a high and stable operating margin compared with its sector, because a benchmark by industry is the only fair one (a 12% isn't the same in retail as in software). And since every figure comes explained with its context, not as a raw number, the more companies you analyze the better you distinguish a healthy operating margin from one that hides a problem.

The operating margin is also a protagonist in valuation. In DeepTicker's Reverse DCF (which discounts cash flows), one of the two big assumptions the price discounts is the evolution of the operating margin: many expensive stocks are only justified if their margin rises over the years toward levels that may not be realistic. As in the system's own example, a stock may require its cash margin to rise from 20% to 32% to justify its price. Seeing that requirement written out lets you judge whether you believe it, instead of accepting the valuation blindly. Quality (moat) and price (discounted cash flow) go hand in hand.