NEW LIGHT ON OLD KPIs - OPERATING MARGIN
Operating Profit Is Important So Is Its Volatility
I will devote a few blogs to important KPI’s (Key Performance Indicators) and discuss their meaning in a new light. I have not heard financial advisors talk about these KPIs in the same simple meaning that I will describe in here. Let’s start this week with the operating margin. In these very uncertain times interpreting these KPIs with a new insight is ever more important.
Revenue and Expense
Revenue of a firm (sales) represents the total billings in the applicable period generated from normal business operations net of discounts. Sales less cost of goods sold (COGS) is called Net Revenue. Some companies do not report COGS separately start their operations reporting with net revenue.
The Operating Income (or operating profit) for a firm is net revenue less Operating Expense ***(OpEx)***. Operating Expenses are expenses of the firm that generate benefits in the current period such as sales and administrative costs, applicable overhead, and rent expense. Expenses not related to the firm’s operations, such are interest and tax payments are not part of OpEx. For many firms, operating income and EBITDA, (Earnings Before Interest Tax Depreciation and Amortization) are the same thing. For banks, interest expense is an operating charge, and operating income is the same as pretax income or EBT (earnings before tax).
Operating Margin (Om) is an important key performance indicator of any firm. It is the ratio of Operating Profit to Revenue. In general, the higher the operating margin the more profitable the firm and the better. High margin means there is more room for error, and when things do not go as expected, there is more distance to disaster. Loosely speaking, operating margin tells us how much revenue can decrease before the firm will run into trouble.
When something goes wrong and revenue decreases, management will try to adjust and reduce costs. Cost of Revenue (COGS) can be reduced proportionally with revenue without much delay. Hence, COGS do not cause a problem. However, Operating Expense is somewhat sticky and often can’t be changed quickly. Management needs time to re-align resources and costs. Unlike we see in many financial models, expenses are not always proportional to revenue. This necessitates looking at the variability of revenue and controllability of costs:
- How volatile is the revenue? How likely is it to change unexpectedly?
- What portion of the costs are easily controllable?
Depending on the answers to these questions, some companies with seemingly low operating margin could be perfectly fine. We can also look at operating margin as a percent of Net Revenue. We can do this in sectors where COGS is a large, important part of the business, and is therefore reported. Let’s look at a few examples from retail and technology sectors, operations of which are very different:
Data from February 2020
|Company||Sector||Operating Margin % Gross Revenue||Operating Margin % Net Revenue|
Note that even when we take out COGS out of the equation, the operating margin for Microsoft and Intel are much higher than margins for Costco and Walmart. Should we all invest in Tech companies and forget the rest? What is the reason to invest in low margin businesses?
Volatility of Income
The likelihood that the operating margin may change is just as important as what the operating margin is. If you have been investing for a while, you know that things change. Profitable companies can turn unprofitable, products become obsolete, unexpected events like the COVID-19 crisis can put a big dent on revenue. Our world can turn volatile. Let Var denote the volatility (square of standard deviation) of these line items.
Var [Op. Income] = Var [Revenue] + Var [OpEx] – CoVar [Revenue, OpEx]
When it comes to accounting, expense is subtracted from revenue. But when it comes to risk, volatility of expense is added to the volatility of revenue, and then adjusted downward to the extent that revenue and expense move together. (Don’t you love statistics!) If expenses increase and decrease with revenues, then there is not too much to worry.
Let’s see what the volatility (standard deviation) of year over year percent change in revenue and operating margin has been for these four large companies in the past eight years, 2012-2019:
|Company||Sector||Volatility of Revenue Growth||Volatility of Operating Income Growth|
Walmart and COSTCO have lower operating margins but only three standard deviation events can put them in trouble. Incomes of technology companies are more volatile. They need more cushion to protect themselves against bad times. This is precisely why having a higher operating margin is somewhat necessary. Some factors that make them more profitable are more R&D spending, pricing power for innovative new products, and always changing the way of doing business. But these factors also contribute to their income being more volatile. Investors of hi-tech companies are playing the higher risk higher return game, which normally pays off except when it doesn't. On the other hand, retailers of essential goods depend on a large population of consumers who need the goods that they sell at a low margin.
In order to understand key performance indicators, just following levels and trends is not enough. We also need to understand how volatile these variables are.
For this, you need data.
Suggested Data References in This Article (ALTADATA Marketplace)
Please share your thoughts in the comments section.