Monday, October 26, 2009

Focus on Operating Efficiency: Net Operating Profit Margin

In a previous installment, I covered a measure of after-tax operating profitability known as NOPAT (Net Operating Profit After Taxes). NOPAT serves as a relevant indicator of a firm's ability to operate efficiently, as it strips away many transitory, one-time items from the picture, focusing only on the firm's core business profitability. From an analytical perspective however, NOPAT may be more significant as a numerator of a ratio than as a stand alone measure. One of the most important such metrics is the Net Operating Profit Margin (NOPM).

Calculating the Net Operating Profit Margin is very easy, assuming however that you can properly ca
lculate a firm's Net Operating Profit After Taxes. See this post if you need a refresher on NOPAT. Anyways, below is the formula:

Net Operating Profit Margin = NOPAT / Sales Revenue

Hewlett-Packard (HPQ) FY 2008 NOPM Calculation

Net Operating Profit Margin = NOPAT / Sales Revenue
= $8591M / $118,364M

To verbalize HP's NOPM of 7.26%, we would say that for every dollar of sales, HP was able to generate 7.26 cents worth of after-tax operating profit. For many companies, operating profit margin may be a more concise measure of performance than the commonly cited Gross Profit Margin. Several small business owners I know are proud of what they perceive to be an impressive gross profit margin at their business. I usually dismiss such talk, as any fool can go out and sell cheaply manufactured products to generate a healthy looking gross profit margin. To pass the NOPM test though, you must be able to operate the organization efficiently and effectively.
Because net operating profit margins vary greatly across industries, it's most productive to compare NOPM's across competing organization's within an industry. Below is a focus on HP and it's primary tech industry competitors from a NOPM perspective.

Clearly, industry leaders like IBM and Apple tend to have very healthy net operating profit margins. There's a little bit of "chicken or the egg" dilemma inherent to that observation; i.e. larger industry leaders are better able to exert their will down the supply chain and operate more efficiently.

Although NOPM is only one element that should be considered when evaluating a company's/stock's relative investment attractiveness, it is nonetheless a very insightful indicator of the profitability of a company's operations.The most important analysis that should be performed as a companion to the NOPM calculation is an evaluation of a firm's leverage. NOPM strips out interest expense, effectively looking at the firm from a non-levered position.I'll get into that portion of analysis later via an examination of the debt-to-equity ratio.

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