When it comes to investing, we want our companies to be the dominant players, the 800-pound gorillas that rule the vines. By picking the strongest competitor, we're giving ourselves and our portfolios a bigger advantage.
Investors may have made money over the years investing in Advanced Micro Devices
In the hurly-burly of the marketplace, though, it's not easy to always tell who is leader or who may be overtaking the leader. One way I like to check on the dominance of a company, or to pinpoint the eventual 800-pound gorilla in a competitive industry, is to compare operating margins, a ratio of the company's operating earnings to its revenues. In general, higher margins mean higher profits.
The information you'll need can be found on the income statement, which summarizes sales and profits over the past quarter or past year. The formula for calculating operating margins is simple:
Operating Margin = Operating Income/Sales
To come up with operating income, or earnings before interest and taxes (EBIT), you subtract from a company's sales all of its operating expenses, which include the cost of goods sold (COGS), sales, general and administrative expenses (SG&A), research and development, depreciation and amortization, and just about every other cost of doing business. Most financial websites will do the calculation for you and show you a line item on the income statement for operating income.
I often use Morningstar.com to get my margin numbers. Most people know Morningstar for its mutual fund information, but it has a wealth of data for stocks, too, including up to 10 years of operating margins. Just click on "Key Ratios" after getting your company's quote.
Tom Gardner likes to pick strong, fast-growing companies for his Hidden Gems newsletter. Let's take a look at one of his best-performing companies, Mine Safety Appliances
Looking at the operating margins table, we see that Mine Safety was the margin leader in the early 1990s, but it stumbled, allowing Lakeland to take the lead toward the end of the decade. Abatix has remained fairly constant throughout and has become less of a concern. At the turn of the millennium and in conjunction with the terrorist attacks of 9/11, Mine Safety has found traction and separated itself from the pack. So even while dipping a little in 2002, it has positioned itself as the industry leader. Mine Safety became the 800-pound gorilla in safety equipment, and it goes a long way toward explaining why it has returned more than 160% since Tom Gardner first recommended it a year ago.
Investors can also use a comparison of operating margins to add a margin of safety to their portfolios. Of course, you'll need to look at more than just margins to make an investment decision, but if you want to swing from the vines and rule the marketplace jungle, starting with a glance at operating margins can have you acting like top banana.
Fool contributor Rich Duprey has been known to swing from chandeliers from time to time. He does not own any of the stocks mentioned in this article.