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When I evaluate a company, one of the measures I consider is its gross margin ratio. I like to see a gross margin that is consistent over time. I also reflect on the story this ratio is telling.
As I've mentioned in previous articles, I'm a numbers person. Gross margin is definitely a numbers thing. But this ratio may also reveal clues about executive priorities, business stability, and competitive advantages.
Let's cover the basics and then consider what the gross margin ratio may be telling me.
Gross Margin and Gross Margin Ratio, Defined
Gross margin represents the amount of profit associated with sales. Financially, it's equal to sales less cost of goods sold. The gross margin ratio is the gross margin (also called gross profit or loss) divided by sales.
For example, drawing from financial results posted on the Fidelity website, Starbucks (SBUX) has this history of gross margin and gross margin ratio:
Sales = $14,892; Cost of Goods Sold = $11,126
Gross margin = $14,892 – $11,126 = $3,766 or Gross Profit (loss) = $3,767 (difference of $1 due to rounding)
Gross margin ratio = $3,766 / $14,892 = 25.29%
Sales = $16,448; Cost of Goods Sold = $11,954
Gross margin = $14,892 – $11,954 = $4,494 or Gross Profit (loss) = $4,494
Gross margin ratio = 27.32%
Sales = $19,163; Cost of Goods Sold = $13,721
Gross margin = $19,163 – $13,721 = $5,442 or Gross Profit (loss) = $5,442
Gross margin ratio = 28.40%
In this case, Starbucks has increased its sales while maintaining and growing its gross margin. A couple of reasons for this steadiness may be the company's position as a premium provider of coffee and the nurturing and control of its supply chain.
Whether Starbucks's stock is available at a fair price is another discussion. Looking at this one measure, gross margin, indicates a positive trend: the company has grown sales without sacrificing gross margin. (Disclosure: I am long on Starbucks).
The Backstories that Go with Gross Margin Ratios
The gross margin ratio often reveals the story that executives are telling customers and/or its management team. Here are a few of the types of backstories associated with gross margin:
We're pushing sales (and ignoring gross margins)
Some companies may experience a decline in gross margins because they push sales without regard for financial well-being. Higher-ups may push sales teams to close deals, sign contracts, and generate revenue with little regard for gross margins. Deals may be struck with unreasonable, unprofitable, and unsustainable price concessions. Contracts may involve difficult and costly to execute agreements for quality, lead times, and delivery time frames.
Execs may rationalize that selling drives business activity and growth. Alternatively, they may have failed to institute safeguards for protecting margin before asking their teams to generate more sales. In either scenario, generating sales without regard for cost can lead to a declining gross margin and serious business problems.
Total profits are more important than gross margin
A hefty gross margin (40+%, for example) seems desirable but, in some cases, executives may decide to focus on generating more sales at slimmer margins. This strategy can work well if the company is able to achieve a high sales volume, particularly greater sales because of lower prices (and lower margins).
A phrase that reflects this business philosophy is “you can't take margin to the bank,” meaning that gross margins are important but not what generates profits and cash, which can be taken to the bank. This approach worked well for Sam Walton as he grew the sales volumes of Wal-Mart into the world's largest retailer.
We'll make it [poor gross margins] up on volume.
Similar to the concept of forgoing high margins to generate sales is the (wrongheaded) idea that a business can generate high sales volumes to cover shortfalls on margins. The business-related joke about this philosophy is that a company with negative margins (losing money on every sale) can turn a profit by increasing its volume.
Walton's intentional approach to accepting slimmer (but still positive) margins to generate high sales volumes worked for Wal-Mart. But businesses may need a higher gross margin cushion to thrive. The important concepts here are to make sure 1) gross margins are positive and 2) the gross-margin approach is consistent with the story that company tells its customers, employees, and shareholders.
We understand the market and our cost structure
A consistent gross margin may mean that executives have a handle on pricing and control of their costs of goods sold. They know what their products are worth and they are able to command that value in the marketplace. In addition, they've built a supply chain that allows them to control production and distribution costs and/or adjust prices aligned with their costs.
Our economic moat allows us to charge premium prices and maintain a large gross margin
A resilient gross margin that persists throughout the years can be a sign of an economic moat. A company with a consistent gross margin is able to charge premium prices for its products and services while instilling customer loyalty. The sustained margin may be a result of economic moats such as patented products, proprietary technologies, or other types of intellectual property or a recognizable and likeable global brand.
You can learn more about economic moats from a common-sense business perspective by reading The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments. The book helped me to recognize wide economic moats that could deliver long-term returns.
I'd like to say that as an investor, I always look for a gross margin of X% that's held steady within X basis points for X number of years. One day, I may have those numbers pinpointed. But for now, I'm looking for consistency of the gross margin ratio and a gross margin ratio that is consistent with its business story.
Do you consider gross margins when evaluating a company and its stock?