Do Profit Margins Actually Matter?

 

I often hear confusion among investors and business people equating high profit margins with high returns.  I understand the confusion.  Returns are all that matter in public markets.  Money begets money which begets money.  The faster that begetting happens, the better.  So when looking at businesses with strong historical returns, we might try to understand what drove those returns to understand what might drive them in the future.  Profit margins play a role, but maybe not in the way most believe they do.

For the huge majority of (we’ll say all) investment situations, there are basically two ways to get a return on an investment:

  1. The business grows its bottom line.  The main driver of business market value is the growth in after-tax profits (unlevered free cash flow) to its owners.  If I buy a business with $10 million in profits, I hope that over time the $10 million turns into $100 million.  More profits = more value.
  2. Have the multiple expand.  If I buy a business for 10x its current profits,  I may get lucky or otherwise and be able to sell the business in the future for 15x its then-current profits.

Simple, but not easy.

Multiple expansion can happen for a number of reasons (interest rates falling, a bull market, industry-specific tailwinds, margin improvements, industry posture, etc.), but over the long-term, multiples will not expand (unless you’re lucky) without after-tax earnings/earning power increasing.

 

Returns On Invested Capital Are King

If the market value of a business follows the growth in its after-tax profits, the better question is what drives the growth in after-tax profits?  We need to focus on ROIC.  What we need to know is:

  1. What rate of return does the business achieve on its invested capital?
  2. How much of its profits can and will be reinvested? 

Kinda simple, but not easy.

With any business as a going concern, cash (earnings) is produced and the business has four choices of what to do with that cash.  It can:

  1. Hoard it
  2. Pay it out as dividends
  3. Buy back stock
  4. Reinvest

Businesses often do a combination of the above.  And if you’re a rational CEO (uncommon), these four choices should be weighed depending on the opportunity set on any given day (i.e. buy back your stock but only when it’s cheap, not all the time, and especially not when it’s expensive).  As the CEO, this capital allocation decision might also depend on the type of business you’re running.

 

The Business Types

As somewhat of a tangent, the two italicized questions above might be easier to answer if we can have a framework for looking at businesses based on their “type”.  In my mind, most viable businesses fall into one of four categories: 

Typical: Most businesses are likely to fall into this typical bucket.  Think of your average restaurant, grocer, or local gym.  These are respectable businesses that provide employment, value to customers, and economic impact, but they don’t have a sustainable competitive edge.  Unless you are a great manager or buy really cheap, these businesses make it hard to earn high rates of return for a prolonged period of time.  In capital markets, we usually try to buy these for $0.50 on the dollar and then sell them when they are closer to fairly valued.

Good: Some businesses have a decent underlying business that produces consistent and continual earnings thanks to entrenched market positions or entrenched products.  Often this type of business is mature and does not have good places to reinvest those earnings at high rates of return – so they pay out most of their earnings in dividends.  Proctor and Gamble or Hershey’s might be good examples of this type of business.  Difficult to kill, though without many enticing reinvestment opportunities.

Better: Rarely there exist businesses like the one described above but with one addition: it has a manager that retains all the earnings and deploys those earnings into new businesses unrelated to the existing entrenched business.  The corporate office acts like an internal private equity fund, using permanent capital supplied by solid entrenched operating companies to fund a disciplined acquisition effort.   These are very rare birds who have exceptional managers who successfully redeploy these earnings to unrelated businesses at high rates of return. Berkshire Hathaway (Buffett) and Danaher are examples of these rare birds.  Most often, businesses who have run out of reinvestment opportunities are diworsification businesses run by managers who can’t sit still, can’t resist the institutional imperative, and have career risk (therefore must act to look busy), so they diworsify.

Best: The rarest and most wonderful business is one that has an entrenched market position with ample opportunities to redeploy earnings at high rates of return.  All profits are plowed back into growing the existing business and that existing business earns high rates of returns and has a long runway for growth.  Google, Geico, or Visa are good examples of these types of businesses.

Remember our two questions?:

  • What rate of return does the business achieve on its invested capital?
  • How much of its profits can and will be reinvested? 

We are looking for businesses that earn high rates of return on its capital and have lots of opportunities to reinvest those profits.  Businesses that fit this bill generally live in the “better” and “best” categories.  They can be compounding machines and true get-rich schemes.  An investment that compounds nicely for years without me having to redeploy any funds is absolutely the best type of business.   (As a side note, these are the types of businesses we don’t want paying dividends.  If the “best” businesses can reinvest in their own business at 15%+, why would a shareholder want to rob that capital, get taxed on it, then try to redeploy it somewhere else to try and replicate those 15%+ returns?)

 

Returns On Invested Capital – What it Looks Like

While looking for potential investments, let’s say I stumbled across the historical financials of Bill’s Burgers (BBS).  I can see that BBS has raised money by both taking on investors and borrowing some money.  The business started with $5,000 in equity and $2,000 in debt or $7,000 in capital.  In its first year, BBS made a profit of $1,000.  The return on invested capital (ROIC) is 1,000/(5,000+2,000) or 14.3%.  In this admittedly simple example, we can answer our first question – BBS earned 14.3% on its invested capital.  We’ll apply this exercise to any subsequent years to figure BBS average ROIC over a longer time period.

The problem with ROIC is that it usually only tells us the rate of return on capital that has already been invested, and sometimes that capital was an investment made many years ago – such as during an IPO.  That’s still a good thing to know, but we should also care to figure out what type of returns BBS can realistically achieve moving forward with any new capital.

I first want to know how much of that $1,000 in profit BBS put back into its business.  In this example, I see that BBS paid its equity holders a dividend of $300 then plowed $700 back into the business.  So BBS had a reinvestment rate of 70% ($700/$1,000) – the answer to our second question.  With a ROIC at 14.2% and the ability to reinvest 70% of its earnings, we are interested in digging deeper.  We might guess that Bill’s Burgers could compound at roughly 9.9% in the future (14.2% ROIC * 70% of earnings reinvested).

With that idea in mind, let’s fast forward 10 years to see how the financials of BBS have turned out:

Year Debt Equity Profits Reinvestment at 70%
1        2,000            5,000          1,000                   700
2        2,000            5,700          1,100                   770
3        2,000            6,470          1,210                   847
4        2,000            7,318          1,331                   932
5        2,000            8,250          1,465                1,025
6        2,000            9,275          1,611                1,128
7        2,000          10,403          1,772                1,241
8        2,000          11,643          1,950                1,365
9        2,000          13,008          2,145                1,501
10        2,000          14,509          2,360                1,651

Stay with me, and I’ll explain this. BBS has increased its annual profits to $2,360 by year 10.  Compared to its year one profit of $1,000, the business has increased its earnings by $1,360 (year 10’s profit of $2,360 less year one’s $1,000 profit) and has invested an additional $9,509 into the business (year 10’s total capital less year one’s total capital).  Put simply, this is the incremental profits created by the incremental investment made. With incremental profits of $1,360 divided by the (re)invested capital of $9,506, we get a ROIC of 14.3%.  BBS stayed pretty consistent.

BBS’ cumulative profits over those 10 years are $15,944.  Out of those profits, the business reinvested a total of $9,509 into the business, so the reinvestment rate was 59.6% ($9,509/$15,944).

Summing it up, over 10 years Bill’s Burgers earned a 14.3% return on incremental capital (answer to question 1) and reinvested 59.6% of his profits at that rate (answer to question 2).  Multiply those two numbers together and we get 8.5% – this annual growth rate is roughly how much value this business has created for its investors.  And like we did above, it is perhaps the rate we expect the business to compound at in the future (assuming business as usual).  We can run a sniff test to see how reasonable this 8.5% value compounding is by comparing BBS actual profits in years 1 and 10 of the business.  Profits went from $1,000 to $2,360 – or a CAGR (compounded annual growth rate) of 8.9%.  When comparing the historical CAGR of profits at 8.9% to our estimated value compounding of 8.5%, it’s relatively close.  A pretty good barometer.

This exercise is a simple and handy one to get a rough idea of the returns on incremental invested capital of most businesses.

This again also shows why I don’t particularly like dividends on businesses that have high ROIC and earn good rates of return on incremental invested capital.  BBS investors (the equity holders) would have a lot more money if they took no dividends and instead let BBS reinvest 100% of the earnings at 14.3%.  Assuming BBS had ample opportunity to reinvest all its earnings, the profits would have grown at a CAGR of 12.8%.  And unless those who received dividends had places to reinvest that money at rates exceeding 14.3% (higher considering they paid tax on the dividend received), they basically robbed themselves of an extra 3.9% annual compounded return – or a 44% higher total return.  In other words, if an investor put $10,000 into a business like BBS, over 10 years an 8.9% growth rate turned their investment into $23,460.  But a 12.8% CAGR turned into $33,350 over the ten years.  Let Bill reinvest.

 

And Finally

Now let’s bring it full circle.  Margins do matter – though we care much more about how they are evolving vs their absolute level.

Let’s look at BBS reinvestment and its effect on sales and the margin.  The data in this table is the same as data already presented on BBS.  Bill’s Burgers ROIC and reinvestment rate are still 14.3% and 59.6% respectively,  the only changes to our original table are the four bolded columns on the right.

Year
Debt
Equity
Profit
Reinvestment
SALES
SALES GROWTH
MARGIN
$ OF SALES CREATED FOR EVERY $1 OF REINVESTMENT
1 2,000 5,000 1,000 700 10,000   10.0%  
2 2,000 5,700 1,101 771 10,487 4.9% 10.5% 0.7
3 2,000 6,471 1,211 848 11,012 5.0% 11.0% 0.7
4 2,000 7,319 1,333 933 11,588 5.2% 11.5% 0.7
5 2,000 8,251 1,466 1,026 12,216 5.4% 12.0% 0.7
6 2,000 9,278 1,613 1,129 12,902 5.6% 12.5% 0.7
7 2,000 10,407 1,774 1,242 13,647 5.8% 13.0% 0.7
8 2,000 11,648 1,952 1,366 15,013 10.0% 13.0% 1.1
9 2,000 13,015 2,147 1,503 16,516 10.0% 13.0% 1.1
10 2,000 14,518 2,362 1,653 18,169 10.0% 13.0% 1.1

This is interesting.  We see that BBS had an average sales growth of about 7%.  For the first seven years, BBS had mild (mid-single-digit) sales growth where profits grew faster than sales – meaning there were margin improvements.  Perhaps Bill got his logistics sorted out and steadily took excess costs out of the business thereby getting more and more efficient.

Starting in year seven, profit margins got stuck at 13%.  In order for BBS to achieve a ROIC in line with his previous 14.3%, the business needed every dollar of investment to produce more dollars of sales.  Bill happened to be a marketing genius and achieved this goal.  Sales growth improved to 10% for the final three years, and each dollar reinvested created 1.1 dollars in sales growth, up from 0.7 dollars the previous seven years.

Switching the scenario, what if the nature of BBS was slightly tweaked and the business was instead a distributor of beef vs. a hamburger joint?  Let’s assume BBS supplies all regional burger joints with their essential beef.  Because the nature of their business is different, their sales and margin results would probably look more like this:

Year
Debt
Equity
Profit
Reinvestment
SALES
SALES GROWTH
MARGIN
$ OF SALES CREATED FOR EVERY $1 OF REINVESTMENT
1 2,000 5,000 1,000 700 90,909   1.1%
2 2,000 5,700 1,101 771 91,758 0.9% 1.2% 1.2
3 2,000 6,471 1,211 848 93,178 1.5% 1.3% 1.8
4 2,000 7,319 1,333 933 98,709 5.9% 1.4% 6.5
5 2,000 8,251 1,466 1,026 112,766 14.2% 1.3% 15.1
6 2,000 9,278 1,613 1,129 129,017 14.4% 1.3% 15.8
7 2,000 10,407 1,774 1,242 136,472 5.8% 1.3% 6.6
8 2,000 11,648 1,952 1,366 139,409 2.2% 1.4% 2.4
9 2,000 13,015 2,147 1,503 165,161 18.5% 1.3% 18.8
10 2,000 14,518 2,362 1,653 181,694 10.0% 1.3% 11.0

We see BBS the distributor has experienced average sales growth of just over 8%, ROIC is still at 14.3%, owners of the business earned the same profits as owners of the restaurant, though margins are around 1.3%.  So, Is this any worse of a business than BBS the restaurant?  My answer is NO.  Absolute margins aren’t the key.  It’s ROIC ($ of sales created for each dollar invested).

We’ll change the scenario one more time and put Bill’s Burgers back to being a restaurant, though this time without the ability raise prices and get margin improvements.  In this scenario, an In-N-Out moved in across the street soon after BBS opened its doors.  BBS had to compete by lowering its prices to lure customers in (and thereby saw its profit margins fall).  For BBS to maintain a 14.3% ROIC, sales growth would have to be dramatic:

Year
Debt
Equity
Profit
Reinvestment
SALES
SALES GROWTH
MARGIN
$ OF SALES CREATED FOR EVERY $1 OF REINVESTMENT
1 2,000 5,000 1,000 700 10,000   10.0%  
2 2,000 5,700 1,101 771 11,591 15.9% 9.5% 2.3
3 2,000 6,471 1,211 848 13,459 16.1% 9.0% 2.4
4 2,000 7,319 1,333 933 15,677 16.5% 8.5% 2.6
5 2,000 8,251 1,466 1,026 18,325 16.9% 8.0% 2.8
6 2,000 9,278 1,613 1,129 23,039 25.7% 7.0% 4.6
7 2,000 10,407 1,774 1,242 29,569 28.3% 6.0% 5.8
8 2,000 11,648 1,952 1,366 39,035 32.0% 5.0% 7.6
9 2,000 13,015 2,147 1,503 42,942 10.0% 5.0% 2.9
10 2,000 14,518 2,362 1,653 47,240 10.0% 5.0% 2.9

Having the same number of reinvestment dollars, BBS would have to somehow translate that invested capital into multiple dollars of sales created for every dollar invested.  Not an easy task as shown by the 19% average sales growth and large dollar amount of sales per dollar of investment.

 

Wrapping it Up

ROIC and the reinvestment rate tells us how efficient and effective the business has been with its capital.  In the three examples above, the same dollar amount of profits were created for the owners of the business.  It’s when we look at the profit margin trends of the business that we might see which businesses are more or less preferable.  Absolute profit margins (i.e. 1% vs. 10%) tell us very little about the quality of the business and the returns it generates for its owners.

 


 

 

PostScript

A Worthwhile and Telling Exercise

Profit margins are the dollars of after-tax earnings created for each dollar of sales.  This is the same thing as return on sales (after-tax profit/revenues).

Imagine you have a choice to buy into one of two businesses below, which would you buy?

Company A Company B
Sales $100.00 $100.00
Pre-tax profit $1.00 $13.50
After-tax profit $0.65 $9.00
Profit margin (profit/sales) 0.65% 9%

Really, choose.

 

I’ll give you a bit more data to help you decide.

Company A Company B
Sales $100.00 $100.00
Pre-tax profit $1.00 $13.50
After-tax profit $0.65 $9.00
Profit margin (profit/sales) 0.65% 9%
Book Value (or Equity) $6.50 $70.00
Return on Equity (ROE) 10% 12.90%

Obviously, Company B with a 12.9% ROE trumps 10% – and has far more profit per dollar of sales as a cushion.

Okay, now choose.

 

Fine, one more piece of data.  We are still missing an important piece of info because we have no idea if that ROE is juiced or not.  We’re missing other sources of capital (debt).

Company A Company B
Sales $100.00 $100.00
Earnings before interest and tax (EBIT) $1.00 $16.50
Interest Paid ($3.00)
Pre-tax profit $1.00 $13.50
After-tax profit $0.65 $9.00
Profit margin (profit/sales) 0.65% 9%
Debt $90 (gross of $16 cash)
Book Value (or Equity) $6.50 $70.00
Total Capital (debt + equity) $6.50 $160.00
EBIT/Total Capital 10.00% 10.30%
Return on Equity (ROE) 10% 12.90%
Return on Total Capital 10.00% 5.60%
ROC (net of cash) 10.00% 6.30%

Let’s assume capital needs for Company A are only the $6.50 in equity – that’s all they need to operate. No excess debt, and no excess cash.  Company B uses a reasonable amount of debt of $90, but keeps $16 on hand for emergencies.  Now we have a balance sheet!

So, what’s the better business?  Company B gets some added production through employing leverage and juices the returns to the equity holders (because debt holders don’t participate in business upside).  And its margins before interest and tax are healthy, providing a lot of coverage for interest payments or other overlooked expenses.  Also, as evidenced by its higher margins, it may be in a less competitive industry, have some type of pricing power, or some other structural advantage. There are a lot of investors who, at this point, would still prefer company B.

So, make your pick.  Which business will you buy?

 

Ah, you want one more piece of data, do you?  Greedy.  Well, we are still missing the most important piece of information. The PRICE.

Company A Company B
Sales $100.00 $100.00
Earnings before interest and tax (EBIT) $1.00 $16.50
Interest Paid ($3.00)
Pre-tax profit $1.00 $13.50
After-tax profit $0.65 $9.00
Profit margin (profit/sales) 0.65% 9%
Debt $90 (gross of $16 cash)
Book Value (or Equity) $6.50 $70.00
Total Capital (debt + equity) $6.50 $160.00
EBIT/Total Capital 10.00% 10.30%
Return on Equity (ROE) 10% 12.90%
Return on Total Capital 10.00% 5.60%
ROC (net of cash) 10% 6.30%
PRICE $6.5 $200
Price/Book Value 1.0x 2.85x
Price/Sales 0.06x 2.0x
P/E 10x 22.2x
Enterprise Value/EBIT ([Market Value + net debt]/EBIT) 6.5x 16.6x

Price matters.  Because we’re able to buy Company A at book value, our return is identical to that business.  On Company B, because we paid 2.85x its book value (bought its equity for 285%), the adjusted ROE to todays investor drops from 12.9% to 4.5%.

Of course, we know absolutely nothing about the industries of these businesses, growth prospects, durability, managers, etc.  Right?

Well, actually we do.

Company A is a wholesale distributor with sales in the $billions, yet operates at about a 1% pre-tax margin.  If the business required $1 in capital investment for each dollar in sales, it would be an absolutely lousy business.  Fortunately, it probably does about 13 or 14 dollars in sales for each dollar of capital deployed.

Company B is not a company at all.  It’s the S&P 500.

You’ve probably guessed my game by now.  As I tried to show in the main section of my post, margins may not matter as much as we think they do.  Sure, understanding where margins might sustainably change for better or worse might matter, but absolute margins don’t matter to the degree most of us think.

Going further; because the margin is the amount of profit per dollar of sales, it matters how many dollars of capital are invested to produce an additional dollar of sales.  This lessens the importance of absolute profit margins and puts the importance squarely on return on capital.  To illustrate what I mean, below I’ve outlined a business with steady 4% (low) margins and requiring $1 of investment to produce an additional $1 of sales (a lousy business although margins remain steady):

Investment Sales Profit ($) Profit Margin (%) Return on Capital
Original Investment 10 50 2 4 20%
One dollar of additional investment 11 51 2.04 4 18.50%
One dollar of additional investment 12 52 2.08 4 17.30%
cont.. cont..
One dollar of additional investment 30 70 2.8 4 4.00%

VS. a steady margin business with each dollar of investment producing $5 of sales.

One dollar of additional investment 11 55 2.2 4 20%

Return on invested capital matters.  Here we can clearly see its importance by the number of dollars the business needs to invest to drive one additional dollar of sales.

So What?

Within the S&P 500, the amount of capital required to produce a dollar of sales has marched steadily upward.  It now takes more than two dollars of retained earnings to produce a dollar of sales, where it only took about a dollar prior to 2000.  This diminishing return on investment is probably not ideal, though there could be other aspects in play.  Some things to think about right off:

  • As capital intensity changes, the significance of a historic range of profit margins for “the market” fades away
  • If ROE is significantly higher than ROC, look deeper to understand why (debt or an understated book value)
  • As capital intensity changes, the cost of capital matters
  • If ROC is lower than a company’s cost of capital, it is destroying value.
  • Returns depend completely on the price paid, so pay attention to what you pay!

The return a business gets on its invested capital matters dearly.  Low margin businesses like Costco (sub 2% after-tax margins) would be the worst businesses if high profit margins were the defining characteristic of a great business.  The true defining financial characteristic of a great business lies in how well a company drives additional sales with each dollar of investment and then consequently, how those sales flow down to the profit margin.

2 thoughts on “Do Profit Margins Actually Matter?”

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