Why Margins are Guideposts for Investors to Overcome Narrative Fallacy

Summary

• The emergence of capital light business models with relatively less depreciation and amortisation provided floor for EBITDA margins to become mainstream in corporate finance world, but some conventional investors have denied the use of new margins metrics.
• Market position, product or service, and quality are among the major factors that shape the margin metrics for the business over a period as it is harder for competitors to replicate similar position, product or service, and quality.
• Margins may look deceiving for growth businesses that are perhaps in the limelight as heavy spending and cash-burn models have increasingly become mainstream over the past decade.

Businesses with almost identical products may have a different cost of products, which primarily is the driver of diverging margin across businesses within competition. Basically, the sales margin means the difference between selling price and cost of sales in a percentage form.

While there are a number of margins from an investor perspective, EBITDA margins continue to be among the popular margins. But investors evaluate businesses through many other margins as well, including EBITDA margin.

The emergence of capital light business models with relatively less depreciation and amortisation provided floor for EBITDA margins to become mainstream in corporate finance world, but conventional investors have shied away from use of new margins metrics.

Evaluating margin metrics of business allows to accurately forecast long term potential of the business, while sustainability of factors, causing margin divergences in a similar group of business, are crucial in evaluating profitability potential and margins.

One invests in businesses simply for an expectation of profits and appreciation of capital, and margins play an important role in evaluating the quality of profits and possible potential for capital appreciation. A business needs to ensure long term survival, which makes profitability a precursor in addition to crucial cash flows of a business.

Margins may look deceiving for growth businesses that are perhaps in the limelight as heavy spending cum cash-burn models have increasingly become mainstream over the past decade. WeWork IPO failure was likely an inflexion point for investors, especially private equity and venture capital.

Uber is still down from its debut price and acquisition of postmates suggests that they are increasing their supply chain capabilities, which may contribute to margins over the future. Moreover, the investment decision of firms sometimes set the trajectory for margins/profitability, cost-efficiency of business model, and margin sustainability of a business.

It is important for business leaders to nurture companies and deliver long term value to all stakeholders. But looking ten years out for an industry or business in this century could be very volatile and uncertain.

Now comes sustainability. It is okay to avoid long term forecasts when variables are constantly changing due to uncertainty, but recalling previous experiences allow to navigate a crisis, making business battle-hardened for survival amid a crisis.

Business specific markets as well as macro conditions continue to evolve for companies, therefore ensuring effective capital allocation decisions becomes imperative for sustainability during a slowdown.

Market position, product or service, and quality are among the major factors that shape the margin metrics for the business over a period as it is harder for competitors to replicate similar position, product or service, and quality.

Gross margin

Gross margins of a business evolve consistently with scale as a business approach to break-even, and business managers emphasise on achieving an acceptable gross margin, which means sales minus direct costs involved.

A better gross margin is reflective of the business position of a company after incurring major costs to produce services or goods. Investments in optimising major costs and inputs for production also adds value to margins of a business.

Managing gross margin is important to deliver better unit economics and competitive edge over its peers. Companies continuously deal with risks and factors impacting margins such as new entry, supply chain issues, tariffs. It also includes steady price hikes based on a range of factors, including primary input costs, inflation.

Meanwhile, the product and its quality set a floor for favourable price discovery or pricing power, therefore margins, moats, and profitability. Moreover, the expected output requires persistent margin management strategy, including investment decisions like the acquisition of an input supplier.

Contribution margin

It can be calculated by deducting variable costs from revenue, allowing to forecast available revenue after variable costs. As compared to gross margins, fixed costs are not included in contribution margin.

It depends on the business model of a company since a manufacturing business that is labour, and material intensive business would incur higher fixed costs as unit production increases. Contribution margins are perhaps used as a precursor for break-even analysis.

Companies use contribution margin to launch a new product and forecast break-even points and profitability of the product, price discovery of product, and structuring of selling expenses. When contribution margin is negative for a product, the business is losing money on each additional unit of product.

A positive contribution margin means that product contributes to profits and fixed costs. Moreover, contribution margins enable efficient resource allocation and cost management, especially in large manufacturing businesses.

EBITDA margin

It means the earnings delivered by a business before interest, tax, depreciation and amortisation (D&A). EBITDA margin is perhaps the best margin indicator for capital light businesses, having relatively lower D&A, with minimal or low debt.

EBITDA allows reviewing the cash generating capabilities of a business and operating expense over a period of time. Drawing EBITDA margin comparisons among peers and evaluating reasons for divergences will allow ascertaining the sustainability of margins.

At the same time, EBITDA could be deceiving for companies with unsustainable debt and capital-intensive business model having large depreciation expenses and capital intensity.

Operating margin or EBIT

It is income generate by the core business of the company before interest and taxes. But operating profit does not exhibit the impact of debt held by the company. Operating profits are considered after considering the impact of depreciation expenses.

Operating margins allow investors to figure out the ability of the business to deliver profits from its core business activities, excluding financing and funding cost. Business that grow its operating margins relatively faster than revenues shows the operating efficiency of the business.

A historical analysis of operating profits would enable an investor to ascertain the cash generating ability of business through core activities. Therefore, a company’s financial resilience to service its obligation.

It is imperative for investors to focus on changing operating margins that could be due to pricing power, brand and quality, cost efficiency, moat – allowing to ascertain the sustainability of margin expansion.

Seasoned investors study the margin profile of businesses across time period, a single period data does not reveal much. Value investors use margin profile study to bet on reversion to mean, while growth investors look for businesses that have ability to sustain the margin and expand over time due to business competitive advantages AKA moat. A quantitive study of Management involves a through profiling of margins viz a viz that of industry. A through study of margins helps investors to validate the narrative behind most businesses.