Reading Between the Lines

When analyzing a company’s revenue growth and operating margins, investors must look further than surface numbers to truly understand the economics of a business. As bottom-up investors, the first thing we do is come up with a base case. We look at the company’s history and how revenue growth has evolved over time. We look at the sources of growth—how much is organic versus inorganic. What kind of investments the company has made to generate that growth. We also look at volume and pricing, when possible, and try to understand how much growth has come from the company’s ability to raise prices. But the most important element is how sustainable revenue growth will be going forward. Have there been industry changes or company changes that would cause revenue growth to deviate from its historical path? The longer the operating history of a company and the less change within the company’s industry, the easier it is to make those kinds of forecasts. Ideally, we like to understand how things are going to change relative to the past to get a sense of what intrinsic value might look like compared to what the market expects.

On the operating margin side, there are a couple of ways to look at it. You can look at it from a fixed-cost versus variable-costs standpoint to understand how much operating leverage the business has and what that business will look like in a downturn. Or we can ask what types of investments the company is making. For a company like Taiwan-Semiconductor, for example, depreciation is a huge part of the cost basis. In other words, it's a highly capital-intensive firm. But understanding this helps us focus on the most important parts of the business. On the other hand, a company like Facebook—even though it is somewhat capital-intensive now—R&D, sales and marketing are huge parts of the investments it makes to sustain a competitive advantage. Another critical point to consider is that operating margin can hide certain things. So, you really want to see what’s driving operating margin and what could cause it to change going forward.

Alphabet, for example, had a business unit that consisted of advertising revenue and cloud services, which were bundled into one reporting segment. Recently, Alphabet split out its cloud services revenue from advertising revenue. In doing so, we learned that the cloud business, which we thought was moderately unprofitable, was highly unprofitable and generated an operating loss of almost $6 billion. That shifted our way of thinking—we now realize that Alphabet’s advertising business is more profitable than we previous thought and, that once the cloud business achieves scale, Alphabet’s corporate operating margin will be higher than we previously modeled.

In the end, growing companies are always making investments. Investors need to understand what part of a company’s cost structure is for growth investments and what part is simply to maintain the existing business going forward.