Shower Thoughts - Why EBITDA Margin Matters
In a mature industry, all else being equal, investors generally use forward EV/EBITDA to value a TargetCo, so the price tag is tied to the absolute dollar amount of EBITDA. Leverage aside, and assuming no multiple expansion / contraction, your return is dependent on how much the forward EBITDA can increase from entry to exit.
From investors' POV, depending on the firm / fund, there may be a min. requirement for EBITDA margin when screening through potential investment opportunities. Why place such a huge emphasis on EBITDA margin of the target companies when its the absolute dollar amount of EBITDA that should matter? Theoretically speaking, would you prefer Company A that has high EBITDA margin but slow top line growth, or Company B that has high top line growth but low EBITDA margin, assuming their absolute dollar amount of EBITDA is the same?
Used as poor proxy for biz quality
Companies that have a high, sustainable competitive moat will have pricing power combined with significant barriers to entry which will preclude new entrants. That results in high margins. Sustained high margins in a mature industry signals that the Company is doing something that is valued by their customers and hard for others to replicate. Examples include traditional CPG, branded consumer product companies (Apple, Coca Cola, etc.). This is also why Buffett likes those type of consumer businesses so much - doesn’t matter what new technology comes out in next 100 years - there is and only will be one Coca Cola.
Think of those two business and ask this question: if raw material costs/labor etc. increase by 1%, what’s the impact on EBITDA?
There's so many other considerations that go into an investment and there's so much deal-specific context, etc. High margins make for a nice checkmark for people skimming company financials to gauge cash generation. Even in your example, it's a really hard question to answer without more info.
Assuming most things equal, like they operate in the same industry, I would assume that Company B is a newer entrant that's rapidly gaining share, and would expect margins to come up closer to Company A over the hold period (assuming they're not gonna continue to give up pricing and erode GP contribution, etc), resulting in higher absolute EBITDA growth. If you're asking about two companies with equivalent EBITDA growth but different margin characteristics...then I'd assume they're either in different industries, Company B is just lazier (read: opportunity to trim fat), or maybe Company A is aggressive AF in cap. labor spend.
These are all overly simplified takes but overall I agree that focus on margin is way too shallow without proper context.
Arguably margin doesn’t matter so much as ROIC or FCF yield on investment. Ultimately the former is a measure of business efficiency and the latter a measure of price-based return quality.
EBITDA is code for bullshit earnings. Gimme dat FCF all day baby. Can't pay people in adjustments.
Wait until you hear about pro forma run-rate adjusted free cash flow.
This is something that has bugged me for a while too. Oftentimes, with higher margin industries, they tend to not be able to grow revenues as fast either (i.e. niche industry). I guess margins matter more when you're comparing two very similar companies which theoretically should be able to grow revenue at similar rates with similar level of difficulty, but one of them just has a better cost structure in order to retain more of that revenue in the form of EBITDA.
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