Wednesday, January 7, 2015

What price does one pay for margins?

Consider that you have a choice between 2 companies:

Company A Company B
Revenue 50.0 100.0
Profit after tax 10.0 10.0
Equity 40.0 40.0
ROE 25% 25%
Net Margin 20% 10%

Assuming ZERO debt and exactly the same growth rate should the valuation of the two be the same or should Company A carry a premium? Surely company A takes home a greater percentage of revenue thereby showing that it has a greater hold on the market. But the fact that the ROE is the same is also interesting because that means no real premium on invested capital is being charged.
  • Are the margins sustainable? If they are Company A should be valued higher. Threat of competition to Company A is higher and thus if its moat is not strong enough sooner rather than later it will be attacked. Pricing power and brand is most important in this case.
  • Can the Revenue/Assets be made more efficient? If yes then company A should be valued higher.
As usual the answer to me seems that it depends on a few factors - three of which have been covered above. Sustainability of margins holds the key. If you can somehow determine that the margins will hold then by all means Company A will be valued higher.

Then comes the question: How much higher?

Typically this will have to be covered by an earnings estimate of the future. The sustainability of margins should be considered within the estimation of the future earnings.