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The Importance of Gross Profit Margin

Posted on May 7, 2020 by Elroy Bicking

To locate the fair value of a common stock, we will need to ascertain the net profit generated by a firm. Dissecting income statement provides us the actions required to locate net profit. One of the critical part of income statement is gross profit.

What's gross profit? Gross profit is the profit obtained after subtracting all variable costs with revenue. For a retail company, it's the difference between the selling price of a product and the price the company bought the merchandise. To put it differently, the gap between what it sells and what it bought.

Gross profit itself doesn't give us lots of information regarding the strength of a company. Gross profit is often expressed in term of percentage. This is known as gross profit margin (GPM). Gross profit margin varies among industries. Retailers normally have a thinner gross profit margin compared to a software firm.

So, how do investors use gross profit margin to examine a firm? Investors can use this tool to describe the competitive advantage of a firm. By assessing gross profit margin trend, the health of a particular business can be determined. There are just three tendencies in gross profit margin. Gross profit margin can go up, down or remain the same. I am going to explain the implication two of these tendencies.

Growing Gross Profit Margin. It's never a bad thing when a company can improve its gross profit margin. Increasing gross profit margin can mean two things for the firm. First, the business has a positive pricing power. When a company raise price because of overwhelming demand, gross profit margin increases. Needless to say, this presumes that variable costs don't increase. Second, increasing gross profit margin may indicate that a firm is becoming more efficient in manufacturing. When price per unit remains the same while the cost of variable unit drops, gross profit margin increases.

Decreasing Gross Profit Margin. Deteriorating gross profit margin isn't favorable to a company. This normally means two things. First, it may indicate that the factor cost has risen as a result of the change in commodity rates. When selling price remains constant while variable price rises, gross profit margin will fall. Secondly, decreasing gross profit margin also implies that a company doesn't have any pricing power. When a company has to cut cost to create sales, this isn't a great thing. When selling cost per unit decreases while variable price remains steady, gross profit margin will decrease.

When estimating gross profit margin for fair value calculation, we will need to look at other things like the business competitiveness, the company's inventory level, new products that are coming out and so on.

By way of instance, when a company has a high stock level, there's a fantastic chance that gross profit margin will eventually suffer. The reasoning is that if you have a lot of unsold items, you need to market it at a lower cost (price cut) to clean your stock. Meanwhile, variable cost remains constant since the item was produced some time ago.

Estimating a reasonable gross profit margin is a must in determining the fair value of your investment. If company A historically have a 20% gross profit margin, you have a fairly good explanation should you quote next year's gross profit margin to be in the range of 60%. Maybe, a new patented product will be published. Or, its biggest competitors might just shut its door, therefore allowing the company to raise price. Whatever it is, it's important for investors to understand the causes of gross profit margin to change.