2. Incremental margin: why today's margin misleads

Level 2: The value drivers

If you take a single idea away from this level, make it this one: the margin that decides a company's value is not the one it earns today on what it already sells, but the one it will earn on the additional euro of sales. They are two different numbers, often very different ones, and confusing them is the most common valuation error after extrapolating growth.

Two margins that are not the same

The average operating margin is operating profit divided by total sales. It is the number that turns up everywhere, and it describes the past: it blends the mature business, the cost base built up over years, and the investments under way.

The incremental operating margin is something else: the change in operating profit divided by the change in sales. It answers the only question a valuation cares about, which is what future growth leaves behind.

Look at it with figures. A company goes from turning over 1,000 million to 1,200 million and its operating profit from 150 to 190. The average margin has risen from 15.0% to 15.8%, a modest improvement. But the incremental margin is 40 over 200, that is, 20%. The new growth is leaving a third more margin than the old business, and the average margin barely hints at it because it dilutes it against a base five times larger.

Why the average is always a step behind

The average margin is a weighted average in which the old base counts for a great deal and the new sales count for very little. If the incremental is above the average, the average rises, but slowly, and it only converges on the incremental after many years of growth. Anyone valuing a business off today's average margin is, without noticing, projecting the economics of the old business onto the sales of the new one.

Rappaport formalized this as one of the value drivers precisely because the difference compounds. One point of incremental margin sustained across a decade of growth is worth far more than one point of average margin today.

The full calculation, with two companies

Imagine two companies identical at the starting line: both turn over 1,000 million with an operating profit of 200, that is, an average margin of 20%. The two grow in exactly the same way, to 1,500 million over five years. The only difference is in the additional euro:

• Company A, a software platform. Its incremental margin is 40%, because serving one more customer costs it next to nothing. Final operating profit: 200 plus 40% of 500, that is, 400 million. Its average margin has climbed to 26.7%.
• Company B, distribution through a physical channel. Its incremental margin is 10%, because every new sale comes through a more expensive channel and at a bigger discount. Final operating profit: 200 plus 10% of 500, that is, 250 million. Its average margin has fallen to 16.7%.

Same starting point, same sales growth, the same five years. One earns 60% more than the other. If you valued them on the same multiple you would be recognizing a difference in value of that same order, and all of it without having touched either the growth rate or the cost of capital.

Where the incremental beats the average and where it does not

This is not sector magic, it is cost structure. The incremental is high when the cost of serving one more unit is close to zero: software, platforms, licenses, brands with a set price. The company has paid for development and infrastructure up front, and that spending already sits in the cost base, depressing the average margin.

The incremental is low, or even below the average, when one of these things happens:

• The mix degrades. Growth comes from products, channels or countries that leave less margin than the current business.
• The volume is bought. Growth comes with discounts, promotions or softer payment terms that are not recovered on the cost side.
• The cost was not that fixed. Many so-called fixed costs are fixed only within a band; go past that band and you have to open a plant, hire a team or double the network.

A practical warning: work with operating profit and with cash taxes, not with net income. Net income drags in interest and financial items that say nothing about what the additional euro of sales leaves behind.

The single-year trap

The incremental margin of one financial year on its own is a noisy figure. A company that opens twenty shops this year which will go on selling for the next decade books the opening costs today against sales that do not yet exist. Its incremental for this year will come out depressed, and not because the business is any worse. The reverse holds too: when somebody shows off a spectacular incremental in a particular year, it is worth checking whether they have simply stopped spending on what sustains future growth. A run of several years says far more than the isolated figure.

A real case: one group, two economies inside it

Amazon is the cleanest example there is. In 2023 the group turned over something like 575,000 million dollars with an operating profit of the order of 37,000 million: an average margin of around 6%. A number that, taken on its own, describes a thin-margin business.

Inside that same group, its cloud services division turned over something like 91,000 million with an operating profit in the region of 24,000 million, that is, a margin close to 27%. Well over half of the group's operating profit came out of a division contributing less than a sixth of sales.

The conclusion is the one this module is built on: the question 'what is Amazon's margin?' is badly posed. The useful question is where the additional euro of sales will come from, because a euro of cloud and a euro of retail are nowhere near equal in value. This is a teaching example, not a recommendation on any security.