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?

 
Best Response

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

 

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.

 
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.

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

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?

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!

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 $)

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)

 

Ratione architecto est et voluptatem consectetur vel ea reiciendis. Quia dolorem cumque omnis qui minus dolor. Et voluptate quidem quia laborum minima non ut dignissimos. Eos fugiat cupiditate autem repellat beatae quia.

Career Advancement Opportunities

March 2024 Investment Banking

  • Jefferies & Company 02 99.4%
  • Goldman Sachs 19 98.8%
  • Harris Williams & Co. (++) 98.3%
  • Lazard Freres 02 97.7%
  • JPMorgan Chase 03 97.1%

Overall Employee Satisfaction

March 2024 Investment Banking

  • Harris Williams & Co. 18 99.4%
  • JPMorgan Chase 10 98.8%
  • Lazard Freres 05 98.3%
  • Morgan Stanley 07 97.7%
  • William Blair 03 97.1%

Professional Growth Opportunities

March 2024 Investment Banking

  • Lazard Freres 01 99.4%
  • Jefferies & Company 02 98.8%
  • Goldman Sachs 17 98.3%
  • Moelis & Company 07 97.7%
  • JPMorgan Chase 05 97.1%

Total Avg Compensation

March 2024 Investment Banking

  • Director/MD (5) $648
  • Vice President (19) $385
  • Associates (86) $261
  • 3rd+ Year Analyst (13) $181
  • Intern/Summer Associate (33) $170
  • 2nd Year Analyst (66) $168
  • 1st Year Analyst (202) $159
  • Intern/Summer Analyst (144) $101
notes
16 IB Interviews Notes

“... there’s no excuse to not take advantage of the resources out there available to you. Best value for your $ are the...”

Leaderboard

1
redever's picture
redever
99.2
2
Secyh62's picture
Secyh62
99.0
3
Betsy Massar's picture
Betsy Massar
99.0
4
BankonBanking's picture
BankonBanking
99.0
5
dosk17's picture
dosk17
98.9
6
DrApeman's picture
DrApeman
98.9
7
kanon's picture
kanon
98.9
8
CompBanker's picture
CompBanker
98.9
9
GameTheory's picture
GameTheory
98.9
10
Jamoldo's picture
Jamoldo
98.8
success
From 10 rejections to 1 dream investment banking internship

“... I believe it was the single biggest reason why I ended up with an offer...”