I never really get when people are hyping up businesses based on i.e., EBITDA margin.
Isn't the only interesting criteria ROIC?
Example: you have a business with 60% EBITDA margin but need to invest hundreds of millions per year in CapEx to maintain that business. What does the high EBITDA margin tell you? Barrier to entry is CapEx in this case.
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Yes you're right Analyst 2!! Fuck margins, who needs sustainable businesses. Really though, yes margin alone is not enough, it's just part of the story. That's why people look at rev growth and EBITDA margin often together to get a better picture of the business. And how those trend over time is also key.
So look at EBIT margin... or E-C margin...
Classic example is automotive industry. I've heard in many IC's - "Look we're creating this at 6x EBITDA!!!" (conveniently ignores the maint. capex that doubles the FCF multiple).
I mean in this situation (FCF multiple twice as high to EBITDA multiple), wouldn't that mean that your EBITDA margin is pretty low to begin with? Thus if there is not a pathway to EBITDA expansion, then its probably not going to be that good of an investment to begin with.
I have never seen any IC that bets on multiple expansion as a base case. You can however increase margins.
And how a deal turns out is a function of the price paid. If you pay cheap enough for this kind of business it can still be a good/great deal.
EBITDA margins have many useful implications. However, the one implication that is relevant to any industry, regardless of capital intensity, is that it is a quantifiable measure of a company's competitive advantage. The greater the inherent competitive advantage, the higher the margin.
This is why a commoditized business like a produce wholesaler commands 10% EBITDA margins, while the niche vertical software business commands +40%.
If someone tells you their business has strong competitive advantages, but only commands 5-10% EBITDA margins, either they're mistaken or they're pricing their product/service incorrectly.
I think it's also useful to compare to industry margins. If a business is generating 30% EBITDA margins and industry does 20%, and there is no clear reason why it is generating 30%, then that should be considered in one's view of normalized EBITDA.
There are a bunch of fantastic low margin distribution businesses with strong competitive advantage
What makes them so fantastic?
Costco has entered the chat.
Obviously there are going to be exceptions and outliers, as is the case for any ‘rule.’
I was more so laughing at the poster referring to Amazon as a traditional low margin distribution business, when it’s clearly not and also generates +17% margins.
I get what you're saying. For example, distributors, food retailers, and drugstores, are businesses with very low margins that can have good ROICs and be an incredible business to own. Margins are important to look at within industries and are an indication of competitive advantages, but are only one aspect in an analysis and people tend to focus too much on it.
Not sure I understand your capex point, investors aren't stupid. Nearly every deal I've done has been on a EBITDA-Capex multiple or if a software business EBITDAC or EBITDAC - Capex basis
A lot of people don't really do critical thinking, and just assume EBITDA margin is relevant from a financial perspective (i.e. "there's more cash!").
But the real utility of looking at margins is:
1) Offers insight into competitive advantage for certain industries (i.e. manufacturers, distributors, retailers, basically any business where output is directly correlated to input)
2) Stability of margins > absolute margin percentage
EBITDA margins by itself mean very little from an investor perspective, without additional context. EBITDA margins can look high for a variety of reasons that have nothing to do with differentiation/ quality of business such as:
1) Accounting gimmick
2) Underinvesting in HC / future growth
3) Focusing on a niche / smaller market
4) High customer concentration
5) New market that hasn’t matured but will soon have a lot of entrants
Conversely, EBITDA margins can look low but it can be a very attractive business.
1) There are plenty of middle-man businesses with low EBITDA margins and high volume (VARs, Distributors, etc.) that are great PE businesses because they are highly re-occurring / predictable, have high barriers to entry and sticky customer relationships, are well diversified, have no technology IP risk, and grow at steady rates.
2) A Company may over invest internally if it improves value to customer and leads to higher growth
3) High gross margins but high fixed costs and company is still scaling
I work in the LMM, and any company that had significant pricing power, high growth in a great market, etc. likely isn’t being sold to me (and if they are it will be at a very high purchase price). Typically those are the firms getting VC / Growth equity money. More times than not, margins converge to some industry norm and it doesn’t really say much about differentiation / durability.
What matters most is the ROIC, which tells you the return on each dollar invested. Equally important are growth and incremental ROIC. A business is particularly attractive if its incremental ROIC exceeds its existing ROIC, as high returns are often eroded by competition. ROIC can be broken down into two:
ROIC = Operating Margins * Capital Efficiency. Thus, while operating margins (post-capex) tell you half the story, the other half is capital efficiency, which varies by industry. By considering both, you gain insights into the quality of the business you are looking at.
How would you come up with incremental ROIC? I always wondered how academics make this heuristic "ROIC * reinvestment rate" = Growth.
This requires the assumption that past ROIC = future ROIC.
It also requires the assumption that growth and reinvestment are directly calculated. What if a software/social media company has immensly high growth (more and more people are buying their product) why would it need to reinvest CapEx for that growth? Isn't that growth coming by itself?
I agree that while it is heuristic, some assumptions are always necessary. The formula ROIC * reinvestment rate is the closest you will get. It's challenging to isolate incremental ROIC because it also depends on your views re strategic direction and industry competition. What I always ask management during DD sessions is what project IRRs management targets. If you set this against past ROIC, you can get sort of a feel in terms of how ROIC will develop (remember aggregate project IRR = firm ROIC). You'll often find that many management teams don't even have an IRR threshold. An extreme case I encountered was a CFO focused solely on EBITDA margins. What you can also do, great back of the envelope, is look at e.g. the last 10-year cumulative operating cash flow and set that at the last 10-year cumulative investing cash flow to gauge returns on investments made.
Growth coming by itself rarely happens, only for businesses that can fully utilise the flywheel effect, which is rare. Generally, growth must come from something, either by paying up for "pay per click" for a social media business or by investing in capacity for an industrial business.
What this really boils down to is that EBITDA matters in the public market. If a PE firms exit ops are IPO or M&A to a public company this is what they will focus on. We aren't for the most part looking at high growth companies where exits are strategic for defensive reasons.
If you want to know why things matter look at the the potential life cycle of something and find out where the things that are being prioritized are valued. That will tell you why.
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