EBIT margin as the name suggests is a ratio of EBIT (Earnings Before Interest and Taxes) to the total revenue of the company. Quoted in %, it is a measure of operational efficiency of the company.
Consequently a higher margin is better than a lower margin. It is unique in that it indicates how well the company is doing in its operations and whether it is generating money primarily from operations as compared to other income as well as eliminate the bias of taxation and debt on profit numbers during evaluation. Its importance shall be explained in detail as we move forward and as always knowledge is easily processed when accompanied by an example so let us look at one while we try to understand this ratio in detail.
EBIT Margin is quoted in percentage terms in the lines of Return on Equity. It is the ratio of Earnings Before Interest and Taxes of the company divided by the Total Revenue of the company.
EBIT Margin = (EBIT / Total Revenue) * 100
All values are available in financial statements of companies. They may be named under operating income or operating earnings but refer to the same number.
Alternatively, it is quite easy to calculate EBIT by subtracting all costs except interest and taxes from revenue to arrive at EBIT.
While evaluating companies, we ideally want to measure how their operations run against each other. Different industries tend to have different structures, costs, regulations and other operational constraints and thus it would not be fair to compare companies across different sectors with each other using operational metrics since an IT company will operate differently from an automobile company and a retail store chain.
EBIT thus is ideal to compare operational efficiencies within the same industry. Things become granular however since even within the same industry, different companies tend to have different business models and thus different operational metrics which again make comparison difficult.
For e.g. an within the automobile sector a passenger vehicle company like Chrysler & Ford will have a different structure and operations to a commercial vehicle company like Volvo or Daimler. EBIT helps identify cost and market leadership amongst companies with likeminded business models in order to identify the strongest company.
Also while evaluating companies internationally, net profit numbers and thus margins will not be a fair comparison as different countries tend to have different taxes as well as interest rates for their debt. An operationally superior company in a high tax country might have less net profit margin than its competitor in a low tax country which can lead to an incorrect evaluation and consequently and incorrect investment.
EBIT Margin helps measure how the company is doing viz. a viz. its operations and whether it is making money from its operations or not. For e.g. you would want a stock exchange to make money from equity transactions and not from other investments or side businesses as was the case of Bombay Stock Exchange. Another name for EBIT is Return on Sales and it helps you identify companies generating their highest return on sales once you remove the impact of debt and taxes from the evaluation.
That is not to say that debt and taxes are inconsequential. However, as an investor you would only want to invest in market leaders with strong operations and efficient cash conversion and that can be found only via EBIT Margin.
As mentioned, EBIT margins are hyper industry specific with even business models being alike. The best place to begin measuring EBIT margins is commodities since all commodities producers tend to have same operations. In our case, we look at some of the largest publicly listed global steel manufacturing companies by volume: Arcelor Mittal (Luxembourg), Nippon Steel (Japan), Pohang Iron & Steel Co. Ltd. now POSCO (South Korea) and Tata Steel (India).
Right off the bat I can see that Nippon Steel and Arcelor Mittal seem to have issues. An operational margin of 0.6% leaves absolutely no scope to absorb interest and taxes as well as any other losses and the same is evident from its Income statement. It doesn’t help that the Pandemic did affect operations and with the world commodities market in a bull run, the company has a chance to improve. Tata Steel on the other hand has a respectable EBIT margin for a commodity industry like steel and POSCO follows suit. However this are not the only indicators for stock performance. This just highlight the strong companies in the sector. There is a confluence of several elements that help boost stock performance.
It is no surprise that Tata Steel has done really well in this commodity bull market with it being operationally strong as well as showing strong revenue growth as well as earnings growth. POSCO has done well too despite showing an earnings decline due to its high EBIT margin. Arcelor Mittal is amongst the top 2 steel producers in the world by volume and its share performance reflects that volume leadership. In the case of Nippon steel, as the saying goes, rising tide raises all boats and Nippon steel stock has been the beneficiary of the commodity market rally despite its subpar performance.
EBIT Margin like any other financial metric or ratio is not a universal solution for evaluating companies. It comes with its own set of limitations and drawbacks and as such it should be used in conjunction with other financial ratios to undertake a complete evaluation of the company under consideration. Its largest drawback is its hyper local comparison.
Forget same sector, companies need to have the same business models as well which makes it completely irrelevant in fields having constant innovation namely technology, pharmaceuticals and biotech. This margin does not take into account depreciation of assets. This is an important financial metric to be left out. Depreciation numbers provide a lot of information about company’s assets, namely whether it is continuously upgrading and innovating vs it using old and inefficient machinery.
It can be mitigated to some extent by comparing EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) margin instead of EBIT Margin. EBITDA can be arrived at by adding depreciation. Finally economies of scale come into the picture. Larger companies by virtue of their size are expected to have better operational margins although not necessarily true all the time. The only way to improve operational margin is to improve sales or cut costs.
One of the easiest ways to cut costs is to have a large scale which distributes your fixed costs over a larger base. Thus larger companies often tend to have an operational advantage over their smaller counterparts especially in commodities businesses. Thus a filter basis EBIT margin will often filter out young but promising companies in favor or larger well established ones.
There is not much ambiguity when it comes to evaluating companies via EBIT margin. The higher the margin the better. All companies with EBIT margins above industry average should make the initial shortlist. It also helps to look at margins of previous years as well in order to eliminate any seasonal or cyclical bias that may have crept in.
For e.g. a food company depending on agricultural products as inputs may have superior EBIT margins one year due to a bumper crop which will suppress crop prices and thus input costs but their margins over a period of 5 years will highlight the true picture of their operational capabilities which one good year might hide.
One can get our premium membership for as low as € 7.9 per month. Just search for any popular company in the sector you are interested in and check out the industry average EBIT margin of that company. Using our premium stock screener, you can screen for EBIT margins greater than the industry average as well as the country you want to focus on.
Once the list of companies has been compiled, filter out the ones as per your sector and evaluate the companies with other ratios and financial metrics.
EBIT margin is a starting point to separate the wheat from the chaff so as to speak. Using EBIT margin, one can filter out companies with strong operations and then deep dive into them further to evaluate via other financial ratios. Always remember that no single ratio is the holy grail of investment selection.
One must build a consensus of various financial ratios like P/E, P/B, and ROE etc. alongside EBIT margin in order to arrive at an investment decision. Alternatively, join our premium membership and we will do all of this work for you, providing you various fair values right on your very own premium dashboard.
In my experience, EBIT margin is fairly useful in commodities and other capital intensive and low margin industries. Industries like software, luxury goods etc. tend to have little fixed costs and immense markup in their prices thus their margins almost always tend to be high across the sector making this metric irrelevant. Capital intensive industries are a different story altogether and only the cost leaders i.e. companies having the best margins in the industry will survive the downward phase of the cycle when it comes. Those operating at substandard margins will be wiped out in a bad cycle and EBIT margins will help you eliminate those companies from your watch list as well as portfolio.
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