Most overlooked yet possibly the most CRITICAL OF financial ratio!
There seems to be some perverse human characteristic that likes to make easy things difficult.
– Warren Buffett
What does Gross Margin tell us?
Investing is a simple process but it is not easy. To fully appreciate the gross margin, we need to understand how the gross profit is derived. The core purpose of a business’s existence is to solve a customer’s problem be it via products or services. (No, not earn profits, that’s the result).
The company takes:
- Base resources like raw material and employee’s working time.
- Focus the resources to PRODUCE GOODS OR SERVICES.
- RESELLS the new value-added good or service to the customer at a PROFIT.
At this point, other items NOT DIRECTLY RELATED to production of the good or service are not factored in such as:
- Depreciation of machinery & equipment
- Backend staff cost (Accountants, Marketing, Advertising & Product Research)
- Property rentals if any
- Non-core business AND one-off income and expense
- Bank Loans & Tax
Revenue – Cost of Goods Sold (COGS) = Gross Profit
Gross profit / Revenue = Gross Profit Margin (%)
Gross margin is the economic value added by the company without having to consider all other expenses and effects of capital structure (source of funds). Because different industries have different norms, gross margin is usually not used to compare companies across various sectors.
However, when you compare the gross margins across companies in the same industry, that’s where the magic begins. The way to use Gross Margins is two-fold.
We may take the average of various industries to discover which industries are more profitable when doing top-down analysis. The second is to analyzs the company’s business moat within that industry when doing a bottom-up competitor analysis.
Gross Margin – The Indicator For Companies With Wide-Moat
Gross Margin is a powerful yet simple tool in determining how strong a company’s economic moat is because of the simplicity of the formula.
The wide-moat business is described as the company who has that deep intangible know-how in a combination of the following:
- The Manufacturing Process – faster, less error prone machinery & process know-how which no other competitor can copy which enables them to be hugely efficient.
- Patents, protected formulas – only they have a right to manufacture which makes it very valuable in the market.
- Constant premium branding / Pricing Power – This allows the market to perceive its high quality. After all, price is what you pay and value is what you get.
Chew on this formula! All the above translates to one or both of the following:
- MORE EFFICIENT internal process = HIGHER PROFIT & MARGIN for the same base resource cost.
- MORE VALUABLE product or service = HIGHER SELLING PRICE for the same base resource cost which flows down to better profits & margins as well.
The key is CONSISTENCY! Firms with excellent long term economics tend to have consistently higher margins which lead to a spiral of positive feedback loop by having the freedom of more cash than other competitors to redeploy expand machinery, improve efficiency, R&D, advertising and marketing which further increase their competitive edge.
As a rule of thumb, we have encountered in industries with Gross Margins:
- Greater than 40% = Strong business moat with low competition.
- Less than 40% = Moderate competition, eroding margins, need to consistently improve to be the top dog.
- Less than 20% = No sustainable competitive advantage, highly fragmented industry. Need to play the volume game to survive.
Within companies, look for the players with consistently higher gross margins among its peers. You would generally realize there is a key competitive advantage for those fat margins. At the same time, you have to contextualise to find out the industry’s norm for gross profit margins.
How do you spot if the business gets easier as it gets bigger or gets more inefficient as it grows? Observe the margins! A good company with a great management would have their Gross Margins increasing if not maintaining as the revenue grows year on year while a company that grows more sluggish as it grows would see a shrinking year-on-year margin.