Revenue Growth vs. EBITDA Margin

If company A has 0% Sales growth but 20% EBITDA Margin while Company B has 20% Sales growth vs 5% EBITDA Margin.
Which company would you prefer to invest in and Why? Any insight on this?

 

Ceteris paribus, the first company is better because its cost structure is better aligned with its revenue stream.

The second company might have more growth but 5% cash flow margins are pretty thin and at that point you should be wary of purchasing it at a given multiple and leveraging it up without taking this into consideration.

It also depends on your needs, though. The first company is a pretty good cash generator while the second company has better possibilities for growth and higher risk.

I'd buy both, merge them together to realize the synergies inherent in the two nearly identical companies, and improve the cost structure while reducing the overall risk of the investment and sell it for a large gain.

 
Khayembii:

Ceteris paribus, the first company is better because its cost structure is better aligned with its revenue stream.

The second company might have more growth but 5% cash flow margins are pretty thin and at that point you should be wary of purchasing it at a given multiple and leveraging it up without taking this into consideration.

It also depends on your needs, though. The first company is a pretty good cash generator while the second company has better possibilities for growth and higher risk.

I'd buy both, merge them together to realize the synergies inherent in the two nearly identical companies, and improve the cost structure while reducing the overall risk of the investment and sell it for a large gain.

If you got asked this in a PE interview, the right answer is almost always Company B. Why? Because as a sponsor, you're looking for both value/growth and room to make an impact. Not only is Company B faster growing, there is also more room as a sponsor to go in there and make things more efficient and also to acquire it at a better value given the initially deflated EBITDA (since transactions are mostly looked at on EBITDA multiples).

There are a ton of items between Revenue to EBITDA (associated with COGS and SG&A) that you can address as a sponsor to cut costs, while fixing a 0% growth business is a much more complex issue.

 
JustADude:
Khayembii:

Ceteris paribus, the first company is better because its cost structure is better aligned with its revenue stream.

The second company might have more growth but 5% cash flow margins are pretty thin and at that point you should be wary of purchasing it at a given multiple and leveraging it up without taking this into consideration.

It also depends on your needs, though. The first company is a pretty good cash generator while the second company has better possibilities for growth and higher risk.

I'd buy both, merge them together to realize the synergies inherent in the two nearly identical companies, and improve the cost structure while reducing the overall risk of the investment and sell it for a large gain.

If you got asked this in a PE interview, the right answer is almost always Company B. Why? Because as a sponsor, you're looking for both value/growth and room to make an impact. Not only is Company B faster growing, there is also more room as a sponsor to go in there and make things more efficient and also to acquire it at a better value given the initially deflated EBITDA (since transactions are mostly looked at on EBITDA multiples).

There are a ton of items between Revenue to EBITDA (associated with COGS and SG&A) that you can address as a sponsor to cut costs, while fixing a 0% growth business is a much more complex issue.

You're definitely right. B is more flippable. We'd personally rather invest in A because we hold long term positions and cash flow out to our investors (though getting it at an attractive valuation would prove challenging).

 

As a credit guy I'd go with company A. Sales are already flat and the business is maintaining 20% margins... what would happen to company B's EBITDA % if their sales took a hit?

[quote]The HBS guys have MAD SWAGGER. They frequently wear their class jackets to boston bars, strutting and acting like they own the joint. They just ooze success, confidence, swagger, basically attributes of alpha males.[/quote]
 

B is probably headed towards a cash crisis and dealing with lots of bad (and reversible) recent management decisions due to the fast growth. Let's assume it's in a non-sexy industry (mfg vs software) with an entrepreneurial owner. They are going to struggle raising outside funding (as SonnyZH said above). The growth is either coming from bad pricing (fixable) or an awesome product offering /sales effort (both great!).

Businesses B is a value waiting to be had. Business A is going to cost you full retail and you better have a plan to grow it.

Backlog, in my opinion might be a more important consideration.

Global buyer of highly distressed industrial companies. Pays Finder Fees Criteria = $50 - $500M revenues. Highly distressed industrial. Limited Reps and Warranties. Can close in 1-2 weeks.
 

I also wanted to point out that if these two companies are in the same industry (ideally doing very similar things), I would pick B because there's a chance for EBITDA growth. A is very appealing from a credit standpoint for obvious reasons, but it might be a very well run company and there aren't any cost synergies. Whereas, you can use A as an example for B if B's revenue begins to taper off and you begin to focus on controlling cost.

I'm sure there's a right answer to this, but a lot of these questions are 1) fit questions and 2) reasoning questions. If you can make a good argument, people will respect you for it.

--Death, lighter than a feather; duty, heavier than a mountain
 

As most of us probably know, there are three ways to generate a return in PE. The first is through EBITDA growth, the second through multiple expansion at exit, and the third through cash flow generation during the hold period.

EBITDA growth is the most profitable given the multiple applied to it (multiple expansion is also great but harder to model in). Company A be may be a better cash flow generator, but Company B has much higher sales growth. Due to fixed costs, it's very likely that Company B's EBITDA will grow by more than its 20% growth rate in sales. Hence there is an opportunity for tremendous EBITDA growth, which makes the risk/reward pretty appealing as there is a ton of value to be created by exit. Therefore I would go with company B (currently work in PE).

 
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