Hi guys! i hope all is well. Quick question. I am struggling to understand the rationale behind why a high EBITDA margin business should, all else being the equal, trade at a higher EV/EBITDA multiple.
I understand the volatility of margins should affect the multiple (more risky means lower multiple) and I understand margins should affect a multiple like EV/Revenues (as margins are not yet “discounted” in the revenues number) but it is really puzzling me why it should affect EV/EBITDA.
Personally I wouldnt mind paying a higher multiple for a leaner/more efficient business, all else equal this quite intuitive for me, but would like to hear how would you tackle this “brainteaser”.
Should the margin really matter for EV/EBITDA or its all about the growth and margin volatility?
Margin should matter for EV/EBITDA, or even EV/EBIT. High margin means you get more from ostensibly doing less. That’s worth paying for.
(Compound growth and volatility are important for just about any ratio involving income statement items, in part because predictability is valued by investors. Just like the P/E ratio.)
To the rationale, if one company is able to generate more EBITDA with every dollar of revenue that comes through the door, their operations are simplistic (i.e. low cost) and/or efficient (a good indicator of this would be if it’s patented). Every incremental bit of sales volume means more profits, so there’s inherently more potential, which investors will pay more for. Think of two farmers, one who has a combine and another who is picking corn by hand. High and low margins, respectively. Alternatively, think of how a company could sell less and perhaps still make as much or more than others. Think of a pharmaceutical company selling expensive but useful cancer treatments and another selling plain old aspirin.