Margins vs. Cashflow

Working through a business model problem—incredibly small margins but has the opportunity for significant cash-flow.

One of the best indicators you can look at in value investing is EBIT / Enterprise Value. EBIT is Earnings Before Interest and Taxes (amount of cash the business generates before financing/tax) and Enterprise Value is the amount you’d have to pay for the entire business today (including debt). If margins are small but the EBIT/EV is high (say 30-40%) that seems like a good business even if margins are small (3-5%).

The market penalizes small margins, the perception being the larger the margin the more defendable the business is. This seems largely right, but there are giant companies (typically commodity firms) built on small margins. At the end of the day, you get paid in dollars, not in margins. So IF, and probably a big IF, you think you can defend your small margins over the long term (i.e. Amazon investing in innovation) then you can build great, low margin businesses.

Or at least I think so?

“Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that. So if you could take the free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins.” “What matters always is dollar margins: the actual dollar amount. Companies are valued not on their percentage margins, but on how many dollars they actually make, and a multiple of that.” “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”

Much more