Hello,
Question: Which company is a better investment?
Company A: 20% Operating Margin, 10% ROIC or
Company B: 10% Operating Margin, 20% ROIC
Assume both companies are in same sector and direct competitors. Also which company may be a better investment for the long run? This is all of the information that is available for the question.
Thanks for the help
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From my conception what drives value are growth and ROIC/WACC spread. So, assuming growth is out of the question, WACC is the same, I believe company B would be a better investment, given valuation multiples are the same. Having a higher margin doesn't help if your invested capital is too high.
To Nutry:
I agree that Company A would have to have a high number of assets being using inefficiently, but how would Company A still be able to generate a higher margin in this case (assuming both competitors are direct competitors)? On the other side would Company A be a better investment for the long run because it will generally have a higher EBIT and therefore generate more cash?
Higher EBIT margin doesn't necessarily mean higher Free Cash Flow... what if a company has a high EBIT margin but needs to deploy a lot more capex every year (utilities for example)? You can get that by analyzing ROIC, that considers Invested Capital.
Do a quick exceI exampIe, higher Operating Margins wins it out in the end
If you get a question like this in an interview, your first task should be to ask clarifying questions. For example, asking basic questions such as who is the investor or what is the investor's horizon would allow you to formulate a better answer. The interviewer will be glad you did.
I disagree -why would investment horizon matter? If one investment offers 15% return and the other offers 10% over the same time frame the choice is obvious.
It makes no sense to say that one of these two direct competitors is a better short-term investment but the other one is a better longer-term investment.
Assuming growth is equal, then higher ROIC wins imo because that company can deploy capital at higher rates and return the excess amount to shareholders. Being able to deploy large amounts of capital at high rates while having low capex requirement is the golden goose of investing.
In reference to the earlier questions of how can there be such a large difference in EBIT margins within the same industry? Perhaps one company company grew organically and has high depreciation expense while the other one grew through acquisition and plowed a huge portion of the purchase cost into goodwill.
So what would be an appropriate answer? It depends?
If you get a question like this in an interview, your first task should be to ask clarifying questions.
ROIC is indicative of how much cash flow the business generates. higher ROIC means you are earning profit with a smaller asset base. a smaller asset base means you are investing less cash in capex and working capital, so more free cash flow. free cash flow (ROIC) is what's important for determining the business value (also, the effects on value of operating profit/margins are captured in the ROIC equation)
so, generally, and assuming growth and discount rate are similar, I'd choose the higher ROIC company. if for some reason you expected that the low ROIC company would be able to dramatically reduce investments in capex and working capital in the future while maintaining higher op margins (this would increase the company's roic over time), then maybe you could make a case for that company, but usually companies can't just stop investing and maintain the same revenue and profitability.
regarding the large margin difference within the same industry, i can think of an example that might work. say both companies are producers of a consumer product. company1 with the high margins and low ROIC manufactures everything in house. company1 doesn't share profits with anybody so op. margins are high but it has a large asset base and high capex requirements to support its manufacturing operations. company2 with lower margins but higher ROIC outsources its manufacturing to 3rd parties. company2 has lower op margins because it has to pass some of the profit to its manufacturers but it has a much smaller asset base and capex spend because it doesn't own the manufacturing facilities.
op. margin difference could also be due to one company expensing rent costs and the other company capitalizing rent costs...I haven't really thought through that situation, though
High ROIC company 100% of the time if there is no other information. ROIC takes a high operating margin into account and is therefore the better measure of firm health...
ROIC = NOPAT/ Invested Capital
NOPAT = Net Operating Profit - Taxes
Net Operating Profit = Operating Margin x Gross Profit
Net Operating Profit = Operating Margin x Sales
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