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Online Tutorial #3: How Do You Calculate A Company's "Operating Profit Margins"?

Changes in future operating profit margins can have a significant impact on shareholder value. This session focuses on where to find the data for and calculate historical operating profit margins and how to project future margins. As with previous sessions, we will use Gateway, Inc., as of April 21, 2000, as a case study. Readers who want to calculate operating profit margins while reading this tutorial may wish to download the accompanying spreadsheet

What Does "Operating Profit Margin" Mean?

To understand what we mean by "operating profit margin," let's break this phrase down into its component sparts:

  • Operating. This means we only include operational expenses in this calculation. Specifically, we exclude all costs associated with financing activities, including interest payments from debt and amortization of intangibles from acquisitions. We also exclude tax expenses from this metric, making this a "pre-tax" measure.
  • Profit. This means we are calculating profits, i.e. what's left after subtracting expenses from sales.
  • Margin. This means we are calculating operating profit as a percentage of sales.

More specifically, "operating profit margin" equals the percentage of sales left after subtracting the following:

  • Cost of sales
  • General and administrative expenses
  • Sales and marketing expenses
  • Research and Development expenses
  • Depreciation of property, plant and equipment.
  • Any recurring non-financing expense associated with a company's ongoing operations

We do not subtract the following:

  • Interest payments
  • Taxes
  • Amortization of goodwill

In accounting parlance, "operating profit margin" is equal to the "EBITA (Earnings Before Interest Taxes and Amortization) margin."

How Do We Calculate A Company's Historical Operating Profit Margin?

Returning to our Gateway case study, we can calculate operating profit margin using two methods:

1. Annual SEC 10-K filings. You can access Gateway's income statement from its fiscal 1999 filings by clicking here. Looking at this page, the information we need comes from this portion of the income statement:

1995 1996 1997 1998 1999
Net sales ($, MM)

$3,676.3

$5,035.2

$6,293.7

$7,467.9

$8,645.6

     Cost of goods sold ($, MM)

3,060.5

4,071.6

5,217.2

5,921.7

6,745.7

Gross profit ($, MM)

615.8

963.6

1,076.4

1,546.3

1,899.8

     Selling, general, and administrative expenses ($, MM)

366.8

607.5

786.2

1,052.0

1,304.1

     Nonrecurring expenses ($, MM)               

113.8

Operating income ($, MM)

249.0

356.1

176.4

494.2

595.7

Note: 1995 and 1996 income statement data was obtained here.

 

Let's walk through the calculation of operating profit margin for 1997:

  • Sales. We start by noting that Gateway had sales of $6,2937.7 million in 1997.
  • Cost of goods sold (COGS). We then subtract Gateway's cost of goods sold of $5,217.2 million from this amount to see that Gateway earned $1,076.4 million in gross profits in 1997.
  • Selling, general, and administrative (SG&A) expenses. Gateway lumps all recurring non-COGS expenses in this one line. In 1997, Gateway incurred $786 million in SG&A expenses. We subtract this from Gateway's gross profit to get to $290.2 in operating profits.
  • Non-recurring expenses. Gateway recorded nonrecurring charges of $113.8 million in 1997, resulting from a write-off associated with acquisitions, a non-cash write-off from an abandoned software project, and severance of employees. Because we are calculating historical operating profit margins to estimate future margins, we do not want to include these kinds of non-recurring expenses in this metric. The only exception to this is when a company repeatedly recognizes "non-recurring expenses." This is not the case here.
  • Margin calculation. We then take the $290.2 million in operating profits and divide it by $6,294 million in sales to calculate that Gateway had an operating profit margin of 4.6% in 1997.

Repeating this calculation for the other years, we see that Gateway had operating profit margins of 6.8% in 1995, 7.1% in 1996, 6.6% in 1998 and 6.9% in 1999.

2. Value Line. Value Line subscribers can avoid running through every income statement item. In the following section, we walk through how to use Value Line data to calculate operating profit margins, with references to this downloadable spreadsheet.

In the worksheet entitled "Value Line Tear Sheet for GTW.xls," we see that Value Line gives historical and projected "Operating Margin." We can see this metric in row 35 of this worksheet.

Value Line defines its Operating Margin as "operating earnings (before deduction of depreciation, depletion, amortization, interest, and income tax) as a percentage of sales or revenues." Value Line's operating margin is equivalent to Earnings Before Interest, Taxes, Depreciation, and Amortization, or EBITDA. As our definition of operating profit margin refers to EBITA, we will need to subtract depreciation to translate Value Line's EBITDA to EBITA. 

To be more specific, we need to follow a three step process:

1. Operating Margin in Dollars. First, we calculate Gateway's EBITDA in dollars by multiplying the Operating Margin numbers in row 35 by the Sales numbers in row 34.

2. Depreciation. Then, we subtract depreciation from this EBITDA ($, MM) number. Fortunately, Value Line includes depreciation in its Investment Survey, which we can see on row 36 In the worksheet entitled "Value Line Tear Sheet for GTW." This gives us EBITA in dollars.  

3. Margin. Finally, we divide EBITA ($, MM) by sales to see Gateway's EBITA margins.

We perform these calculations on Value Line's historical and projected numbers for Gateway:

1997 1998 1999 2000 2001 2003-5
Sales 6,293.7 7,467.9 8,645.6 10,600.0 13,800.0 30,000.0
Sales growth (%) 25.0% 18.7% 15.8% 22.6% 30.2%  
Operating (EBITDA) Profit ($, MM) 377.6 597.4 752.2 954.0 1,242.0 2,850.0
Depreciation ($, MM) 86.8 105.5 134.1 160.0 205.0 415.0
EBITA ($, MM) 290.8 491.9 618.1 794.0 1,037.0 2,435.0
EBITDA Margin (%) 6.0% 8.0% 8.7% 9.0% 9.0% 9.5%
EBITA Margin (%) 4.6% 6.6% 7.1% 7.5% 7.5% 8.1%

Note: Value Lines numbers for 1999-2004 are estimates. This is why Gateway's 1999 EBITA margins reported to the SEC (see above) do not agree with the Value Line estimates.

 

How Do We Estimate A Company's Future Operating Profit Margin?

We can estimate a company's future operating profit margin using one of four  methods:

1. Detailed analysis. An example of a detailed analysis can be seen in Expectations Investing. Specifically, on pages 96 and 97, we analyze Gateway's historical operating margins. We use this historical analysis as a starting point for our estimate of a company's future operating margin. We explain the reasoning behind our estimate of Gateway's future operating profit margins on page 99.

2. Value Line. As we showed above, Value Line's company-specific Investment Surveys offer data points that we can use to infer EBITA margins (%) in the past and future. In the absence of a detailed analysis, we find Value Line's projections to be a reasonable place to start your margin analysis.

3. Wall Street reports. Analysts in the investment community write detailed reports, often accompanied by detailed historical and projected financial information. If you can obtain these reports, they may offer helpful information in your Price-Implied Expectations Analysis.

4. Companies. With the advent of Regulation Fair Disclosure (FD), companies can no longer selectively disclose financial projections to Wall Street analysts or buy-side investors. Thus, companies are increasingly publishing their "guidance" on future financial metrics when they report quarterly earnings. Searching a company's investor relations web site may prove fruitful.


Sidebar: Amortization of Goodwill

We can also reverse expenses associated with Gateway's annual amortization of goodwill associated with mergers and acquisitions. For example, we can infer the size of this expense in 1999--buried in the SG&A line--by looking at the relevant table in Gateway's 1999 10-K:

1998 1999
Accumulated amortization of intangibles ($, MM)  $   (25.3)  $   (38.9)

Using these two numbers, we can infer that Gateway expensed the difference between these two amounts, or $13.6 million, in goodwill amortization in 1999. Because this is a non-cash charge that has no economic counterpart, we should add this amount back to Gateway's operating profits. In this case, however, Gateway's annual goodwill amortization of $13.6 million only represents 16 basis points of net sales. Thus, we can safely ignore this adjustment in this case study.

However, please note that in cases where a company has done a lot of acquisitions, intangible amortization expenses can significantly affect operating profit margin calculations. Also, please note that goodwill amortization rules have been recently been modified by the Financial Accounting Standards Board (FASB).


 

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