The Little Book of Valuation by Aswath Damodaran

Author:Aswath Damodaran [Damodaran, Aswath]
Language: eng
Format: epub
Publisher: Wiley
Published: 2011-03-17T23:00:00+00:00

To get from revenues to operating income, we need operating margins over time. In many growth firms, the current operating margin will be either negative or very low, largely because up-front fixed costs associated with infrastructure investments as well as selling expenses directed towards getting new clients (and future growth) are counted in the current year’s expenses. As the company grows, margins should improve. Conversely, some growth companies enjoy super-high margins because they have niche products in markets too small to attract the attention of larger, better-capitalized competitors. As the firm grows, this will change and margins will decrease, as competitors emerge. Under Armour’s success with microfiber apparel is a good example; in the initial years, larger players like Nike ignored it but are now introducing their own competing products.

In both scenarios—low margins converging to a higher value, or high margins dropping back to more sustainable levels—we have to make judgment calls on what the target margin should be and how the current margin will change over time towards this target. The answer to the first question can usually be found by looking at both the average operating margins commanded by larger, more stable firms in that industry. The answer to the second will depend upon the reason for the divergence between the current margin and the target margin. With infrastructure companies, for instance, it will reflect how long it will take for the investment to be operational and capacity to be fully utilized. Under Armour currently has a pre-tax operating margin of 12.25 percent, which we see increasing slightly over the next 10 years, primarily from economies of scale, to the industry average of 12.72 percent in year 10.

Value Driver #2: Sustainable margins

Success attracts competition and competition can hurt margins. How strong is your company’s competitive edge?

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