Blog

Weekly research notes covering the full spectrum of asset classes

The Threshold Margin: When Incremental Sales Generate Value

December 4, 2018 / Stefan Larsen

With a bit of intuition and some real-world experience, it isn’t difficult to identify companies with great sales prospects. In 2016, before Fortnite and Overwatch were on the news, understanding that young people liked video games would have been enough for you to earn astronomical returns by investing in brands such as Activision Blizzard, Take-Two Interactive, and EA Games. However, being the first individual to discover a firm with great sales prospects doesn’t necessarily make it a good investment if those sales won’t generate a lot of value. To tell us the degree to which sales revisions generate value for a business, we have a useful financial ratio called Rappaport’s Threshold Margin. To understand how this ratio works and how it can be used, we must start with an explanation of how shareholder value is generated.

At the most fundamental level, shareholder value is only generated when the return on invested capital is higher than the cost of acquiring that capital. If the return on capital is too low, revenue cannot drive value because the subsequent cash flows cannot be reinvested into the business to generate more cash. In other words, the present value of incremental Net Operating Profit After-Tax (NOPAT) doesn’t exceed the incremental investment.  What are the ways in which returns can be influenced as to widen this wedge? The present value of incremental NOPAT increases with the greater sales growth promised by incremental investment, greater operating margin, and the smaller cash tax rate. With greater capital efficiency, less investment is required to generate a given return. Therefore, the magnitude of shareholder value added from a given sales expectation revision is a function of higher operating profit margins, lower cash tax rates and greater capital efficiency.

If you assume a static level of capital efficiency and a constant cash-tax rate given a sales expectations revision, the greater the operating margin, the greater the shareholder value added. But where does the threshold margin fit into all of this? To answer that question, the threshold margin is a critical value that considers capital intensity, profitability, and the cost of capital. It represents the minimum operating margin necessary for a business with a given capital efficiency and tax rate to benefit from positive sales revisions. The greater the spread between the business’ operating margin and the threshold margin, the more NOPAT a business generates with every dollar of additional investment enabled by sales. Assuming you use a Capital Asset Pricing Model (CAPM)- based Discounted Cash Flow (DCF) valuation method, with a growing perpetuity at the inflation rate, the threshold margin is the following formula:

In practical terms, the threshold margin can explain why re-evaluations of companies like EA and Activision Blizzard were so significant. These well-run and profitable businesses have sales as a turbo-trigger due to the substantial spread between their operating margins and threshold margins. It also explains why analysts and investors are so obsessed with the margins and other operating performance metrics of companies like Tesla, which the market expects will perform well in terms of sales, since the lack of efficient operation means that the sales opportunities will eventually evaporate.

The understandings illustrated by the threshold margin can improve outcomes by giving priority to trading or investing ideas with greater sensitivity to the basic business statistics on which one may be speculating, rather than ideas involving inert equities with less upside. Whether you’re a long-term investor, momentum-investor or event-based trader, I think you can benefit from the following principles. With small spreads between operating and threshold margins, sales revisions are unlikely to drive substantial revisions in corporate value, while with a large spread between threshold and operating margins, sales revisions will have a very dramatic effect on the revised corporate value. If a company has great sales prospects already, operating changes that improve capital efficiency and profitability will have a large effect on revised corporate values, while with low sales prospects, operating performance revisions will have little impact in either direction.