Margins vs. ROA/ROCE
If you are to sit down and look at a company with razor-thin EBIT margins (lets say 2%) but great ROCE numbers (lets say 25%), I'm struggling a bit to figure out, what does that tell you about the quality/profitability of the underlying business?
I mean, clearly it tells you that its not an asset-intensive business, but from the standpoint of attractiveness of the business model - would the industry described above be the kind of industry you want to be invested in?
Curious to see if anyone has some smart ideas on this
Thanks
In very broad terms you're asking if a company with tiny profit margins but with virtually no assets required to generate those profits is an attractive business model and the answer is it really depends. You can't really answer that without a whole bunch of qualifiers - so here goes: I'm assuming you're referring to return on capital employed (EBIT/fixed assets-current liabilities) as opposed to return on common equity (if it is the latter, then the explanation could just be that the business is very highlighy levered).
Ok, so assuming you are talking about return on capital employed, one example of what you're describing is the supermarket industry - they have razor thin margins and surprisingly decent ROCEs - (especially those that use operating leases because most of their fixed assets are off the balance sheet). Which is part of the issue - the "real" ROCE is actually much lower. Some companies showing high ROCE may really be have lower "real" ROCE because their intangible assets, leases, and other assets are left off the book value calculation.
Software companies that are starting up, depending on whether their intangible assets and cash are included in ROCE may also show this kind of dynamic for a short period of time (it should be included, but if it isn't, then, voilà , high ROCE). Also, banks could show this relationship if you leave our the loan portfolio from the ROCE definition (although again, this becomes a fairly meaningless exercise if you take out the loan portfolio).
Hope this helps
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