IBD Interview Question: which company would have a higher multiple
Assuming two companies with the same net profit margin, one has higher gross margin, but lower operating margin; the other has a lower gross margin but higher operating margin. Which one has higher multiple? Which company would you buy?
My answer is that the one with lower gross margin but higher operating margin will have higher multiple and that is one that I would buy. My reasoning is that the one with higher gross margin but lower operating margin will incur a high SG&A which are often fixed costs like marketing, advertising and administrative fees. Therefore, it will have a high operating leverage, higher breakeven point, more affected by external environment and demand change, and thus less earnings stability, and thus lower multiple.
Not sure if my logic is correct or am I missing some parts of the story?
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I would have given you a point for trying :) Jokes aside, I think you rushed to try and answer the question directly. Take your time, it's okay sometimes to say 'On top of my head I'm thinking this x, but let's walk through the thinking together'
My response may be going a bit too far, but hopefully it gives you some extra colour on the type of discussions i'd like to engage with candidates
1) Clarify basic assumptions with the interviewer: the two companies have the same sales? Do they have the same valuation (EV)? Is the multiple the interviewer referring to either EV/EBITDA or EV/EBIT (sounds dumb but trust me, during interviews some analysts or even junior associates are trying to be smartasses...)
2) If questions in 1) are affirmative then all else being equal, the company with the lowest operating margin will have the higher multiple (ie same numerator, lower denominator)
3) Which one would I buy? I can't give you an answer, it depends on a number of factors
a. if the two companies are similar (sector, sales, EV) and generate the same net income, my instinct would be to buy the one with the lower multiple => it's underpriced vs its peers for the operating cash flows it is generating
b. but if I was an investor buying a controlling stake, I would probably buy the company with the higher gross margin, and figure out why this company is underperforming vs its peers on the operating margin level - ie, cut some of the corporate/admin costs etc.. See it this way: if you can get your company to decrease your SG&A to the level of the other company, you are automatically generating more profits - corporate efficiencies is the first area we look at in m&a for efficiencies.
c. remember, the two companies are generating the same net profit. Assuming both have a vanilla tax structure, this means that the company with the higher operating margin also has higher interest expense. Therefore it's got higher leverage or a higher cost of funding (or both), which is probably why it has a lower multiple as investors factor in the higher level of debt. If you're a PE investor you may want to buy the other company - which is generating the same level of revenue & profit but with less debt - and plug more debt on top of it.
my 2cts
Interview Question - Higher multiple for a business (Originally Posted: 11/14/2011)
If you were buying a vending machine business, would you pay a higher multiple for a business where you owned the machines and they depreciated normally, or one in which you leased the machines? Cost of dep. and lease are the same $ and everything else constant.
The answer says EV of both companies is the same. Leasing cost however is reflected in SG&A (therefore reflect in EBITDA); while dep cost is not reflected in EBITDA. So multiples in the leased situation is higher.
But can I argue the company on the other hand has the option of selling the machines and might have gain on disposal?
Also, if we look at P/E, both situations (leased and depreciated) generate the same multiple?
I agree with you on most points, except "c. remember, the two companies are generating the same net profit. Assuming both have a vanilla tax structure, this means that the company with the higher operating margin also has higher interest expense. Therefore it's got higher leverage or a higher cost of funding (or both), which is probably why it has a lower multiple as investors factor in the higher level of debt. If you're a PE investor you may want to buy the other company - which is generating the same level of revenue & profit but with less debt - and plug more debt on top of it."
Let's assume the two companies are otherwise the same (i.e., both are in theory equally leverageable) and it is true that the difference is Interest Expense (and not other non-recurring gains/losses like sale of an asset), it actually doesn't matter to the PE firm. As a PE buyer, for the most part I don't care what kind of existing debt structure is in place because I'm going to put in a brand new capital structure anyway. The easiest example is if I'm buying a house for $100, I don't care if the original owners have 100% equity in the house or if they only have a 20% down payment and the remaining $80 is debt. I'm going to pay $100 for the house regardless because that's how much the EV is. What could impact this is if the company with a lot of debt has a huge make whole premium where there is a very large penalty to prepaying the debt off early, which in that case it could impact the PE firm's decision because that's a real cash outflow that will impact returns.
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By "everything constant" I assume he means that valuation / EV is constant as well...
EBITDA of Purchasing Company A is higher (ceteris paribus, adding back D&A increases EBITDA) than Leasing Company B (remember OpEx is above line)
Therefore, the valuation would dictate that Company A trades at a LOWER EV / EBITDA multiple
The EV's being equal is a simplifying assumption... very unlikely in practice
Ask yourself: if depreciation = leasing costs, what would be the incentive for CapEx outlays? Your CapEx always occurs at t=0 but CF benefits of depreciation only occur in the outer years (time value of $)
All else equal, Company A will stand to generate significantly less FCF in this scenario than Company B (run through the DCF in your head, NOPAT line is the same...add in D&A but subtract out CapEx)
You could also assume equity value of both companies were similar, but in reality, Company B is worth much more than Company A.
EV(A) == EV(B), but A is asset-heavy + probably has much more net debt and the probable case is that equity(B) > equity(A).
Thank you for your response! Extremely insightful!
I agree with you. But I'm just wondering should we take into account the effect of possible "gain on disposal"? Or the "gain on disposal" is immaterial and very unlikely to happen? (or i'm over-complicating)
Looking too much into it, the question's just trying to test your knowledge of income statement items
But if you want to over-complicate it, I would counter that vending machines would probably depreciate to zero value and yield no gain even if there was any sale.
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