Spotting quality companies: margins, returns, debt
You do not recognise a good company by one strong year, but by many. Three questions help: is a lot reliably left from every euro of revenue? Does the company earn a lot on the money it uses? And can it carry its debt even in a bad year?
Why quality matters
Every valuation rests on assumptions about the future. For a strong, stable company those assumptions come true more often than for a fragile one. Quality therefore does not make fair value higher, but more reliable. And a reliable value needs a smaller margin of safety.
1. Margins: what is left from revenue
The operating margin is profit from the business divided by revenue. 20% means: from every euro of revenue, 20 cents remain before interest and taxes. High margins often show that a company can set its prices. Even more important than the level, though, is stability: margins that stay calm over ten years, even in crises, are a strong sign. Margins that swing a lot show a business that depends on the weather outside.
2. Returns: what the capital employed brings
A company needs capital: for factories, warehouses, software. Return on invested capital (ROIC) shows how much profit it earns on that capital. If it stays clearly above what capital costs, the company creates value with every euro it invests. If it is below, growth even destroys value – the more it grows, the worse.
Persistently high returns are often the most visible sign of a moat: without an advantage, competition would have pushed them down long ago.
3. Debt: what carries in bad years
Debt is not bad in itself. It becomes dangerous when one weak year is enough to put a company in trouble. Two measures help:
Net debt to EBITDA: debt minus cash, divided by earnings before interest, taxes, depreciation and amortization. Roughly, it says how many years the company would need to pay off its debt from the ongoing business. Interest coverage: profit from the business divided by interest. It shows how many times the company could pay its interest out of profit.
The worked example
Two made-up companies have the same revenue. At first glance they look similar; on the three questions they part ways:
| Measure | Company A | Company B |
|---|---|---|
| Operating margin | 20% | 6% |
| Return on invested capital | 15% | 4% |
| Net debt to EBITDA | 0.8 | 6.4 |
| Interest coverage | 20× | 1.3× |
Company A could pay off its debt in less than a year and pay its interest twenty times over from profit. Company B would need over six years, and even a slight drop in profit would no longer cover the interest. Even if B looks cheaper, it carries far more risk.
Look over many years
A single number says little. Only the trend shows quality: do margins and returns stay high over ten years, even in weak times? Is debt rising faster than profit? A company that holds its figures through a whole economic cycle is usually more robust than one that only shines in good years.
Three common mistakes
Quality at a glance, over many years.
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Frequently asked questions
What margin is good?
It depends heavily on the industry. More telling than a fixed number is the comparison with similar companies and with the company's own history – and how stable the margin has been over the years.
What is the difference between ROE and ROIC?
Return on equity (ROE) measures profit on the shareholders' capital, return on invested capital (ROIC) on all capital employed, including borrowed money. A company can inflate its ROE with a lot of debt, but not its ROIC.
Are debt-free companies always better?
Not necessarily. Moderate debt can make sense if a company earns more with it than it costs. What matters is that it can carry it safely even in a weak year.
Does this also apply to banks?
Only to a limited extent. For banks, debt is the business itself. They have their own measures, more on this in the article How to value banks.
Not investment advice. All content is for informational and educational purposes only. Companies A and B are made up.