Operating margin is probably the most useful profitability ratio because it’s much less volatile than net margin, but includes all operating expenses to run a business (which gross margin doesn’t).
Obviously we want to see increasing operating margins over time. But how’s an investor to know if a company’s general levels of operating margin are good or not?
That’s where this post comes in; we will examine average operating margin from 20 years of S&P 500 data, and hopefully gain a valuable tool on comparing companies and their profitability.
Introduction to Operating Margin
The operating margin formula is the following:
Operating Margin = Operating Income / Revenue
Remember that all margins formulas are trying to describe how much $1 in sales will convert to either gross profit (gross margin), operating profit (operating margin), or net profit/ income (net margin).
So, how do we calculating operating income?
Most of the time you should be able to find operating income in a company’s consolidated income statement wedged in between the top line (revenue) and bottom line (earnings). It’s also sometimes denoted on the income statement as EBIT (earnings before interest and taxes).
You can also derive operating income from revenue by subtracting the following:
Operating Income = Revenue – Cost of Goods Sold – Other Operating Expenses
Where, Other Operating Expenses = SG&A, (selling, general, and administrative) R&D (research and development), and D&A (depreciation and amortization).
Let’s take a business that’s easy to quantify and show how to denote the difference between operating expenses and other expenses in the income statement.
Example of Operating Expenses: Apple
There are many parts of a business that contribute to the products that we love from Apple, such as the iPhone.
A product like the iPhone will embody the entire process of expenses; some get classified as operating expenses and some do not.
Let’s start with how an iPhone is built.
There will have to be manufacturing and assembly plants to create an iPhone from its various component
(1) – COGs
The expenses associated with this part of the process get categorized under Costs of Goods Sold. Whether that’s the salaries of managers and employees working at the plant, the price to purchase these components or raw materials themselves, or even the shipping and transportation costs will all generally flow to Cost of Goods Sold.
It’s the first operating expense to consider, and it’s included in operating margin. Think of Cost of Goods Sold as everything in the manufacturing process.
From there, we have a finished product, and the company needs to make money on the product.
(2) – SG&A
This is where Selling, General & Administration comes in. The company might hire a marketing agency to craft a masterful advertising campaign. They might hire employees to work the stores and sell and service the phones. They pay rent on the store fronts that are needed to sell the product to consumers.
All of the marketing with a product and service goes under SG&A, and is this second component of operating expenses to remember.
(3) – R&D
Thirdly, we have Research & Development.
In order to stay competitive in the market for smartphones, Apple needs to invest significant capital into R&D teams to experiment and innovate on features and technology for the iPhone. Though the impact of these expenses might not be apparent upfront, these are still annual expenses a company needs to pay as they pay their scientists and engineers.
You might be catching onto a trend here—much of operating expense is comprised of the necessary people who keep the business successful, whether that’s in manufacturing, selling, or planning for the future.
(4) – D&A
The last and final operating expense to consider is depreciation (& amortization).
If Apple wanted to build their own in-house factory instead of contracting it out to another company, it would need to invest a lot of capital in order to erect it. It might take multiple years of profits in order to invest in such a facility, and it might also generate multiples more of its expenses to build, in the form of future profits.
Because large investments such as a facility (or other long term assets, called Property, Plant, and Equipment) represent a huge upfront cost, it’s not a good representation to take that charge on a company’s financial statements all at once.
So, long term investments into PPE assets are depreciated over multiple time periods; the expenses to build these assets are spread over many years instead of charged into one.
It helps investors and business owners alike to see how a business is really performing from year-to-year. If long term assets weren’t depreciated, companies would have huge, lumpy losses in their financials each time they made a significant investment, which isn’t much of an accurate description of the actual operating results of a business from year-to-year.
This depreciation charge reduces income, and specifically operating income, which is our last expense to consider.
Why Operating Margin is Such a Useful Metric
Operating income is often a chief focus of companies when they report earnings results, and it’s usually the only consistent metric you’ll find if you’re comparing multiple segments within a large corporation.
This is because as you move from Operating Income to Net Income, there’s lots of other messy charges and additions to the numbers which can depart from the results of the underlying business.
Take taxes for example. Taxes for a large corporation, especially one operating in multiple municipalities or countries, can be a nightmare to follow. The timing won’t always line-up in a smooth fashion, making earnings lumpy. But because taxes aren’t part of operating income, we don’t have to worry about them mucking up Operating Income results from year-to-year.
Operating Income, and thus Operating Margin, is much cleaner than Net Income, but also more descriptive than Gross Profit.
Because of this nature of the metrics, it’s easier to compare companies with each other, and certainly between peers in an industry.
When Operating Margin Isn’t As Useful
But you also need to be careful about relying too much on Operating Margin and Operating Income and automatically assuming one company is better than another just because it has a larger Operating Margin.
The fact of the matter is that some businesses are inherently less expensive to run. Some technology companies like those in software don’t generally have to spend much on manufacturing, since everything is in the virtual world of the internet and computers.
This makes gross margins higher, which flows down to operating margin.
Of course, a software company still needs to sell its products and services like anyone else, and also needs to spend enough on R&D to remain relevant (and probably even more so than the average business).
But even after taking those parts of operating expenses into account, asset-light software companies tend to have higher operating margins than more capital intensive firms. This does not automatically make them better or more valuable investments however.
When Low Operating Margin Is Actually Preferred
A lower operating margin can actually be ideal for a company in certain situations.
For one, having lots of capital requirements can actually thwart competition because businesspeople might not want to deal, or might have difficulty at times, with acquiring enough capital to get started or continue to compete in such an environment.
Also, depending on the situation, the lower margins company might find a competitive moat simply from the fact that many other large businesses (who are more capital efficient) will probably stay away from such an industry, as they won’t get as high of a capital return on their investment in a low margins business than elsewhere.
That can be a great source of value for an investor particular when the stock market is very expensive.
Where you do want to see higher operating margin is compared to direct competitors. Business models can differ, but companies competing in the same market often face similar constraints, and oftentimes the better businesses tend to see their success play out in higher comparative operating margin.
That all said, yes in general you want to see higher operating margin across the board.
Businesses which gush free cash flow through higher margins tend to be fantastic compounders of capital, due to how little reinvestment is needed through additional expenses and capex.
But to truly understand operating margin we have to look at both the positives and negatives, which we’ve done here; keep them in mind as we look at the average operating margin data.
Average Operating Margin for the S&P 500 (2001-2020)
In order to get a good sense for where the baseline operating margin falls, I took a look at the past operating margin for all of the current constituents of the S&P 500.
I did not adjust to add former constituents to the dataset, and so the fact that the operating margin starts to skew higher could be heavily influenced from companies who became weaker and left the S&P 500 and are not represented in this data.
Regardless, it’s close enough for our purposes and was really eye opening to me.
The average for each of these annual figures over the complete 20 year period was 14.3%. Compare this to the 8.9% average from the research I did on historical average net margins.
A nice rule of thumb shortcut would be to remember that net margin probably averages around 10% and operating margin averages around 5% more than that.
Simple and easy.
So a business with an operating margin of 20%+ is probably very capital efficient, while one with 5% or less is pretty capital intensive.
Average Operating Margin By Sector and Industry (2001-2020)
Let’s look at these by sector now, and observe those that are more capital efficient with those that are not so much.
It shouldn’t surprise us to see sectors like technology score average operating margins in the 20s, while sectors filled with capital intensive industries such as Industrials had most years averaging closer to 15.
Note that the totals at the bottom for each year can wildly differ from the median Operating Margins up above for the entire S&P 500.
This is because the nature of averages will cause even one or two extreme figures to wildly distort the average, which is why I use medians instead of averages whenever I can. In the case of this data and the use of a PivotTable in Excel, that’s not an option (that I’m aware of). So years like 2007 and 2004 are wildly off base, and the average of all the sectors doesn’t represent most of the S&P 500 itself.
Now, onto some of the individual industries.
Hopefully you’re able to see the average operating margin data clearly like I’m able to on my 4k monitor. You see quite a bit more variation on these industries than just the simple S&P 500 average had, as over 25% wasn’t too uncommon. Low to mid single digits operating margins was also pretty common.
All in all, it’s important to remember the most critical part of analyzing businesses using operating margins—always compare to an industry, compare apples-to-apples, and don’t use the metric in a silo.
That goes for all of the metrics we teach here on the blog.
Operating Income and its components are helpful in painting a picture on how well a business is performing and how strong its business model is over time, but that’s just one picture to the whole puzzle.
We still have to be diligent in learning about the actual businesses themselves, which takes going past the numbers and into the 10-k’s.
I know reading 10-k’s is not easy and overwhelming at first, but like Dave says, think of it like eating a pizza. You’re gonna want to go slice by slice.
Doing diligent research like that will go a long way in providing confidence and conviction in your investments when the going gets tough.
It’s hard to stay compelled about a company based solely on its numbers, especially when those great numbers temporarily disappear.
Learn business models, understand their competitive advantages, and think deeply about how each business can thrive. And then importantly, combine it with foundational investing principles such as diversification, dollar cost averaging, and long term time horizons.
Have fun in the journey of the stock market and don’t get too caught up in the details if you’re feeling frustrated by them.
I hope this post has given you insight and encouragement along your way.