Article Synopsis: Investors interested in the ability of a company's management to build shareholder value may want to consider a tool called the threshold margin, which ties together operating margin with many key value drivers.
Several weeks ago, while reading Creating Shareholder Value: A Guide for Managers and Investors by Dr. Alfred Rappaport, I learned about a useful investing tool called the threshold margin. The threshold margin is the operating profit margin a firm must achieve in order to earn its cost of capital. Rappaport calls this the "economic break-even" for the firm.
The threshold margin is attractive because its calculation contains many key value drivers, such as sales growth, fixed capital investment, and working capital investment. Calculating the threshold margin requires several steps that can be made much easier through the use of a spreadsheet. Here's an example using EMC(NYSE: EMC).
The first step is to calculate the incremental fixed capital investment rate:
EMC's incremental fixed capital investment rate is as follows:
Incremental fixed capital investment
Fiscal year (FY) 1999
Capital expenditures
$524,279
Depreciation expense
$447,114
Incremental fixed capital investment
$77,165
Incremental sales
$1,279,452
Incremental fixed capital investment rate
6.03%
The next step is to calculate the incremental net working capital investment rate for the firm:
Incremental net working capital investment rate = Incremental working capital investment / Incremental sales.
EMC's incremental net working capital investment rate is as follows:
Incremental working capital investment
FY 1998
FY 1999
Accounts receivable
$1,292,790
$1,625,438
Inventory
$620,025
$618,885
Accounts payable
$299,412
$370,055
Accruals
$457,122
$611,052
Working capital investment
$1,156,281
$1,263,216
Incremental working capital investment
$106,935
Incremental sales
$1,279,452
Incremental working capital rate
8.36%
The third step is to calculate the incremental threshold margin:
Incremental threshold margin = ((Incremental fixed + Working capital investment rates) * (Cost of capital)) / (1 + Cost of capital) * (1 - Tax rate).
EMC's 1999 income tax rate was 26%. We'll also estimate EMC's cost of capital at 13.50%. Using these figures and our results from above, EMC's incremental threshold margin is 2.31%.
The final step is to calculate the threshold margin:
EMC's threshold margin =( ($834,267) + (2.31%) * ($1,279,452) )/ $6,715,610, which is 12.86%.
During fiscal 1999, EMC's operating profit margin was 18.48%, which easily exceeds the 12.86% threshold.
Why Is This Important? The threshold margin is important for several reasons. First, many professionals and individual investors use stock screens to narrow the universe of common stocks to a manageable level before conducting further due diligence. Many of those stock screens include sales growth as a factor. However, if a company does not earn at least its threshold margin, an increase in sales growth will not create shareholder value. Rappaport provides a proof in his book to illustrate that an increase in sales growth does not create shareholder value if the firm earns only its threshold margin.
Many investors also use operating margins as a gauge for performance. The threshold margin ties together the operating margin with many key drivers of shareholder value. Managers that use the threshold margin can determine projects that are likely to increase, rather than destroy, shareholder value. The threshold margin may also prove useful as a comparative tool. For example, an investor studying EMC may want to compare its threshold margin to that of other leading storage providers such as IBM(NYSE: IBM), Network Appliance(Nasdaq: NTAP), and Hitachi(NYSE: HIT).
The threshold margin represents another tool in a financial analyst's toolbox. It is not a traditional financial metric, but may be helpful for investors focused on assessing the ability of management to build shareholder value.
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