Chapter 9 : Operating Profit Margin

Look out for companies with high profit margins.

Warren Buffet

It is very important to understand the business model of the company - what the company is doing and how it is making money. The business model of the company directly impacts the investment rate and the Operating Profit Margin (OPM) of the company. This is defined as a percentage of operating revenue. "If Revenue is Vanity - Cash is King - Margins is Sanity." This is the fifth step in the process of valuation.

Operating Profit Margin (OPM) is the ratio of Operating Profit to Sales and is calculated by dividing operating profit by sales.

Operating Profit is sales (operating revenues) less expenses (excluding finance costs). To arrive at the operating profit, all the expenses including cost of goods sold, selling and distribution, manpower, administrative expenses and depreciation &amortization (though there is no cash outflow) are deducted from sales (operating revenues). Further, the operating profit should not include other income.

Operating Profit is the Earnings Before Interest and Income Tax or Operating EBIT. In other words, it is EBITDA less depreciation & amortization. Other income should not be included while computing EBITDA or EBIT.

Further, we also need to remember to deduct Depreciation & Amortization from Gross Capital Expenditure to arrive at the correct Cash Flow as Depreciation & Amortization is already deducted in arriving at the Operating Profit.

Target Operating Profit / Target OPM

A significant portion of the Shareholder Value is in the Terminal Value (capitalization of last year's NOPAT to Perpetuity). The Target Year's Operating Profit After Taxes is the key driver for this Value, Therefore it needs to be determined carefully.

A significant portion of the value of a company is in the terminal value (Capitalization of the Free Cash Flows in the Target Year of the forecast Period to perpetuity). The target operating profit or Target OPM (Operating Profit in the last year of the forecast period) is the key driver for this value therefore, one needs to determine the Target OPM or Target Operating Profit carefully. Here, economies of scale and operating efficiencies have all played out.

One important point, to be taken care of, is to add back amortization to arrive at the Target Operating Profit, as amortization is generally arrived from goodwill, which is primarily derived from acquisitions.

Example for Computation of Operating Profit for Black Bay Pizza

Table 5 illustrates the computation of Operating Profit for Black Bay Pizza based on the following assumptions:


Forecast Period 5 Years
Sales in Prior Period 100
Sales Growth, CAGR 1-3 Years 15%
CAGR 4-5th Year 12%
Operating Profit Margin in Prior Period 15%
Operating Profit Margin 1-2 Years 15%
Operating Profit Margin 3-5 Years 18%

Table 5 - Computation of Operating Profit

Year 0 1 2 3 4 5
Sales 1,000 1,150 1,323 1,521 1,703 1,908
Operating Profit 172 198 273 306 343
OPM (in %) 15% 15% 18% 18% 18%

The Target Operating Profit for Black Bay Pizza is 343.