Wall Street analysts often obsess over a company’s operating margin – to the point where a 20bp move in in one quarter can cause confidence to collapse and the share price to plunge. Perhaps this shouldn’t surprise us given the importance of margin to the present value of a company. But this narrow focus on small movements often leads analysts to overlook much bigger questions. Here are a number of things that I think a fundamental analyst should be looking for beyond these quarterly movements

  1. Does the business have a “worthwhile” margin?

Phil Fisher, the legendary growth investor, recommended focusing your efforts on those businesses with a “worthwhile” profit margin. He steered clear of companies that he considered “marginal” (i.e. very weak margin). The problem with these marginal companies is that when times turn bad the low margins easily turn into losses, from which it can be hard to recover. In order to make his judgment, Fisher would always consider the margin over a number of years, not just one quarter.

  1. Is the margin appropriate to the business model?

Industries with high capital intensity often go hand-in-hand with very high margins. This doesn’t mean that they are always great businesses – in fact the returns for these businesses can be poor because of the capital investment required (think Telecoms). Equally, in industries where capital-intensity is low, a company can generate very solid returns despite modest margins. When thinking about margins, always pay heed to the capital intensity of the business.

  1. Peer Comparison

It’s often valuable to compare the margin to peers and to determine why margins are different. These differences can be the most illuminating part of your analysis: Is it because of a higher cost base? Greater marketing spend? Are there advantages of scale at play? This also helps to draw out the opportunities and the threats: Is the company over-earning? Or is there potential for the company to be making similar margins to the best companies in the industry? Many a sell side model has been build on a company reaching the “gold standard” within its peer group (although I’ve rarely seen this play out in practice).

  1. Margin Structure

Don’t just analyze the margin at the EBIT level. Look at what the Gross Margin is too.   Where EBIT is poor because Gross Margin is poor then it may be that the company has a product issue or a manufacturing issue. Where the Gross Margin is good but the EBIT is poor, work out why this is. Does the company have inflated overheads? Is it spending huge amounts on R&D? In some instances this may be a deliberate policy of management to invest in promising growth areas (think Amazon).

  1. Historical pattern

Looking at the historical pattern of margins can tell you a great deal. Look to see how much they fluctuate and the range within which they fluctuate. What does this tell you about the margins today – are they at the top or bottom of this range? And what are the factors that have impacted the margin historically? This analysis is particular valuable for cyclical companies, where you need to get an approximate sense for where the company currently stands in the cycle.   Finally, compare history to what consensus is forecasting for the future. Are these expectations realistic given what the company has achieved in the past.

Tom Beevers is the CEO and CoFounder of StockViews.com, a crowdsourced marketplace for equity research.

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  1. […] Margins give you a better handle on how the cycle affects a stock. How far do margins rise in the good times, and how far do they fall in a downturn? (or do they go negative?) Do margins fluctuate from year to year or do they stay within a tight range? More information on studying margins is provided here. […]

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