What are the company’s cost and margin structure?
The investor must understand the past cost and margin structure and changes in the same. The purpose is to look at the long-term trends of cost and margin. The future is unknown, but this assessment can provide cues as to what can happen in the future.
Here is an example of two companies in the paint sector.
The operating margin is in the range of 16% - 22%. ROCE ranges from 59%-30% and consistently declining. The decline in the ROCE numbers must be assessed.
The operating margin is in the range of 8% - 14%. ROCE ranges from 13% - 28%.
Both these companies operate in the same sector and have to deal with similar competitive forces. But clearly, Asian Paints enjoys a high margin and high ROCE.
Once a leader in the telecom sector enjoys a high operating margin but low ROCE.
This company may not qualify for the quality tag and as per Buffet’s definition belong to the gruesome category i.e. high Capex requirement and low return on investments.