Let The Thumb Rule

Take about 100 capital goods companies with a market capitalization above $1bn, half of which listed in North America and the other half in Europe. Run a regression analysis seeking to establish a relationship between operating margin and gross margin across the sample over a 5-year period. What do you get? 0.4x.

Whether its gross margin stands at 20% or at 50%, the average Diversified Industrials company generates an operating profit equivalent to 0.4x its gross margin. The exact same relationship can be observed for North American and European companies.

Only c. 12% of the sample manages to achieve a ratio of 0.5x, with 0.6x representing the maximum observed in our sample—the frontier between the possible and the impossible.

There is some logic to the relationship between gross and operating profit. The operating profit is a direct reflection of the operating expenses and capex (through the depreciation charge) incurred to generate the gross margin (next to the invested capital in terms of working capital). It is equivalent to an input-output ratio. Significant operating expenses in terms of R&D, SG&A and capex are required to drive a high gross margin. Where the gross margin is capped (pricing power), the operational expenses and capex/depreciation have to be set at a commensurate level.

There are important limitations, though, including:

  • The analysis takes a static approach to gross margin. A temporary misalignment can be the result of investment in operating expenses or capex to boost the gross margin where possible (again, pricing power)

  • Operating expenses can be substituted by working capital to support a high gross margin (e.g. high inventory for a fast product delivery response) which means that a high operating margin/gross margin ratio could be compensated by a lower capital efficiency (and vice/versa, for example in the case of advanced payments)

Notwithstanding the above, the 0.4x rule of thumb may be useful to assess and market any operational improvement potential, and the degree of operational excellence for existing operations or potential targets, at least as a starting point.

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