Question:
In determining the value of a business, how important is it to consider the earnings percentage – i.e. earnings as a percentage of overall revenue? All things equal, if I’m looking at businesses with a certain amount of earnings, am I better off with a business with lots of revenue, and relatively low earnings percentage, or a business with a high earnings percentage and much lower revenue?
Answer:
These are all excellent questions! I think it’s difficult to simply broad brush an answer to you specifically because different businesses/industries will have a wide range of earnings as a percentage of revenues. As an example, service business will typically enjoy enormous margins compared to distribution companies. Therefore, if you wish to have this figure play a significant role, your only considerations should be: is the net profit percentage after add-backs in line with industry standards and, second, how do the profits of one compare to their like businesses.
The question of which is better: higher profit percentages or revenue is strictly personally. I certainly prefer businesses that have higher margins, and I am less focused on the revenues. In fact, of my five golden rules that any business must have, high margins is one of them (the other four are: sales and marketing driven, element of exclusivity in product/territory, demand in place, don’t compete on price). The reason why high margins are more important to me is because my strength is in sales and marketing. I know I can build a business’ sales and so if the margins are strong, the profits will surely follow. Conversely,
it is difficult if not impossible to significantly impact the margins of a business.
Sure
you can cut expenses but the only long-term meaningful way to build a business is to grow the revenue.
Therefore,
if the margins and profit percentages are good, you’ll experience meteoric increases in profit as you significantly increase sales.
So in a long winded way, my preference would be to