Profit margin in company valuations

business acumen
New answer on Jul 11, 2021
4 Answers
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Anonymous A asked on Jul 10, 2021

What is the role of profit margins in estimating company valuations (for a PE case)? I thought a company was valued based on how much profit it could generate? Why do we need to look at profit margins?

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Ken
Expert
replied on Jul 11, 2021
Ex-McKinsey final round interviewer | Executive Coach

It's a good proxy to understand the company's ability to generate cash which would ultimately pay off the debt. This is why PEs like light asset high margin businesses with recruiting revenue/cash flow.

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Francesco
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replied on Jul 11, 2021
#1 Coach for Sessions (4.000+) | 1.500+ 5-Star Reviews | Proven Success (➡ InterviewOffers.com) | Ex BCG | 9Y+ Coaching

Hi there,

Profit margin per se is not relevant indeed. What matters for valuation purposes is the absolute amount of Free cash flow or of the variable you use related to a multiple to compare with the market ratios (eg EBITDA, Net Earnings).

Profit margin could be indirectly used though to calculate the absolute amount of, say, the net earnings (eg if you know revenues are $100M and profit margin is 5%, then you can calculate net earnings as $5M).

In terms of the valuation techniques, you can find more here:

https://www.preplounge.com/en/consulting-forum/valuing-a-company-10550

Best,
Francesco

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Ian
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replied on Jul 11, 2021
MBB | 100% personal interview success rate (8/8) and 95% candidate success rate | Personalized interview prep

Hi there,

You may need profit margin in order to actually calculate profits! (I.e. we know their revenues are x and their profit margins are y, solve for profits).

If profit margin is being considered in addition to profit margins, it's because that's an indication of future ROI! Arilines make horrible investments and hover around 5% margins. Cloud computing (AWS) is a fantastic business to be in and have margins in the high tens.

High margin generally means you have an attractive company! They know how to make a dollar worth a more!

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Henning
Expert
replied on Jul 11, 2021
Bain | passed >15 MBB interviews as a candidate

Agree with Francesco, but would add another lens. Depending on the context of the rest of the case, you might use the profit margin as an indicator for the potential value. Especially in  competitive biddings, the funds often also incude a value creation plan in the valuation. (e.g. current free cash flow is low, but if we go through the following measures, we can easily increase FCF to x).

Profit margin might be an indicator you use to judge that. If, for example, all competitors have profit margins of ~5% and your target only has similar size but a margin on only 1%, you might infer that there is potential for either pricing or overhead cost reduction.

Again: Highly dependent on the case and not applicable in a cookie-cutter tool box, but that is why it's so important to tailor your approach to every case.

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Ken gave the best answer

Ken

Ex-McKinsey final round interviewer | Executive Coach
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