Strength of EBITDA Margin in Adverse Market Conditions

Background

Mid-pandemic market recuperation was the product of protracted quantitative easing and low interest rates. This led to low unemployment and bullish market sentiment, but regrettably cascaded into high inflation, economic uncertainty, and investor unease as inflation continued its upward momentum into 2022. High inflation in North America required the introduction of economic tightening measures to limit the level of economic contraction. The product of increased rates brought about a selloff in the equity and real estate markets.[1] Further, a decrease in consumer spending in tandem with the supply chain shortages and energy crises prompted economic decline amongst the largest economies. These problems are underscored by the United States-the largest economy-as it sustained more than two quarters of economic contraction, this qualifies it as being in a “technical recession.”[2]

Exhibit 1: NASDAQ Returns Against S&P 500 [3]

Equities have steadily declined over the past twelve months, and the waters ahead remain choppy and unpredictable. The continued lifting of interest rates could lengthen the downtrend in the financial markets. The NASDAQ has experienced a sizeable downslope due to uncertainty in the market, that has impelled investors to withdraw from technology stocks in favor of more value-driven stocks; in sectors such as Financials, Consumer Defensives, and Utilities.[4]

EBITDA Margins as a Buffer for Market Volatility

The market has tightly relied on the opinions of the Federal Reserve for forward guidance on interest rates, economic growth, and inflation. This guidance has historically caused an increase in market volatility, due its influence on overall market outlook and investment decisions.[5] As Technology companies experience a slide in their share price, a level of cushion is provided by EBITDA margins. As depicted in the chart below, EBITDA margins in increments of 20% from >0% to 60% were evaluated to ascertain the relationship with percentage price decrease from 52-Week Highs. The data demonstrates the correspondence between stronger margins and a lower share price fluctuation for tech companies. Naturally, this relationship can be expected due to EBITDA Margin being an important indicator of financial strength.

Exhibit 2: Share Price Fluctuation in Relation to EBITDA Margins[6]

Decline in Tech

As seen by the NASDAQ’s downward trend, tech multiples have declined by 137% over the past 12 months, this is the product of shrinking equity values. As this transpires, companies are taking increasing measures to mitigate loss, including workforce reductions and hiring cutbacks.[7] This trend will continue in line with economic contractions, consequently taking a toll on tech companies.

Exhibit 3: Declining Tech Multiples[8]

Final Thoughts

As global economic conditions remain poor, we can expect it to trickle down into non-defensive sectors, and correspondingly into the financial markets. Tech companies with stronger EBITDA margins will prevail through market shortfalls and resist the impeding flight from tech stocks. The continuation of trends discussed above will perpetuate the current slide that the market is enduring, and a turnaround in high inflation and interest rates is required to precipitate market turnaround.

[1] IMF: World Economic Outlook – Update July 2022

[2] International Banker: US is in a Technical Recession Despite Upward Q2 GDP Revision

[3] Yahoo Finance

[4] CNBC: Analysts say investors should flock to […] ‘defensive’ safe havens amid uncertain markets

[5] Bloomberg: Fed’s Forward Guidance Is Increasing Market Volatility

[6] Pitchbook

[7] Yahoo Finance: As Tech Valuations Fall, Companies Rethink Stock Options

[8] Pitchbook