7/01/24
Margin Analysis
Author: David Sun
Editor(s): Kushagra Sadwal
One step investors commonly use in evaluating companies is margin analysis. The margin of a company is its profit divided by gross revenue. In analyzing a company, investors often examine the margins of the company and consider the possible implications for said margins. For example, we could take the margins of two competitors and compare them. If one company has significantly higher margins, we may interpret that as a good sign. Here are a few commonly used margins:
Gross Margin
The formula used to calculate gross margin is (Gross Revenue - Cost of Goods Sold) / (Gross Revenue). In other words, gross margin measures the ratio between gross profit and gross revenue. As one would expect, a higher gross margin is better. Generally, investors look for the gross margin of a company to be above 30%, but this varies from industry to industry.
Operating Margin
The formula to calculate operating margin is (Operating Profit) / (Gross Revenue). Operating profit is also earnings before income and taxes (EBIT). Naturally, a higher operating margin is better. As a rule of thumb, an operating margin of over 15% is good, but, as always, a comparison between competitors within the same industry is far more accurate.
EBITDA Margin
The formula to calculate the EBITDA margin of a company is (EBITDA) / (Gross Revenue). EBITDA stands for earnings before interest, taxes, depreciation, and amortization. In simple terms, EBITDA is the operating profit of a company without accounting for the cost of maintaining its equipment. For example, if a baker makes $100 off a week's supply of dough but must expend $10 to maintain the condition of the dough mixer, the EBIT would be $90 and the EBITDA would be $100. As with all of these margins dealing with profit, a higher EBITDA Margin is generally considered better. However, it’s important to make industry-wide, not market-wide, comparisons when analyzing a company’s margins.
Conclusion
As a rule of thumb, higher margins are better. By comparing various types of margins, we may better understand the cost structure of a company and its competitive positioning.