A margin is simply a ratio to sales, a percentage of the sales. This tells you how profitable the company is. There’s a few main margins that you’ll come across:
- Free Cash Flow Margin – this is the free cash flow divided by sales. So it tells you what percentage of sales ends up as free cash flow.
- Operating Margin – this is the operating income divided by sales. It tells you what percentage of sales ends up as operating income.
- Net (Income) Margin – this is the net income divided by sales. It tells you what percentage of sales is earned as net income.
- Gross Margin – this is the gross income divided by sales. It tells you what percentage of sales is earned as gross income.
More Free Cash Flow
Higher margins will mean that for every dollar of sales you make, you will earn a higher amount of free cash flow (or operating income, or net income). Let’s take two companies, each with $100million in sales. Company A has free cash flow margins of 20%, and company B has only 10%. Company A will have $20million in free cash flow, whilst company B will garner only $10million. That’s a huge difference, double the margin means double the free cash flow, which should mean double the value of the company.
Growth Has Bigger Impacts
Another benefit of high margins is the impact of growth. Let’s say both of those companies grow by 10% next year – company A will have sales of $110million, as will company B. However, company A will have free cash flow of $22million whilst company B will earn $11million. So company A now has $11million more in free cash flow than company B, whereas last year company A had $10million more in free cash flow than B. So higher margins will mean that growth in sales has a bigger impact on total free cash flow.
Provides Protection in Downturns
The other benefit of high margins is that it provides the company with a buffer in a downturn. If your company has higher margins, then it will need a larger drop in sales before it starts losing money. Let’s say company C and D both have fixed costs of $20million, these are costs that they will need to pay each year regardless of how many sales they have. Let’s say that company C and has an operating margin of 20% and D has 10%. Company C will have operating income of $0 when its sales are $100million, whereas D will reach $0 when its sales are $200million. So you can see that company D needs to make more money to breakeven when compared to company C. So if there’s a downturn for these companies, C will be able to stay afloat more easily than D. Another benefit of higher margins.
Tells You the Company Strength
The margins can tell you a lot about the strength of a company – the strength of its moat. Free cash flow margins of 10+% are good, whilst margins of less than 5% are bad, and everything between is average. If a company has high free cash flow margins, this may indicate that its a strong high-quality business. You must be a company with a strong business model (strong moat) in order to earn high margins than the average, and you must be a company with a weak business model (weak moat) in order to earn low margins. The gross margins are gross income divided by sales. Gross income is entirely dependent on the direct costs associated with your business – these are the costs that are directly associated in making your product. If the gross margin is high then it means that the company can charge much higher prices for its product, much in excess of how much it costs the company to make the product. How can you charge high prices for something that costs you relatively little to make? A strong moat – a strong business model. So when you see high margins (free cash flow, gross, operating, or net), it usually means that the company has a strong moat (business model) that allows it to get away with doing this. This is another way to identify a good company.