The Gross Margin ratio explained.

The Gross Margin (also known as Gross Profit Margin) is a “profitability ratio” that measures gross profit to sales revenue. It reflects the profits of a business after paying off its costs to produce its goods and services (COGS). The ratio is reflected as a percentage showing each dollar of revenue that is retained as gross profit. Whatever money is left over after a company subtracts all the costs to deliver its product or service gives us the Gross Profit Margin.

It is an important financial metric to look at the financial health of a business (and investment). A higher sustained GM can indicate that a business is generating strong profit from its operations and not spending a lot of revenue on sustaining those core operations.

The margin is often used when comparing businesses of different sizes and different industries. Like all valuation and comparison of investment opportunities, we must measure like for like. Some industries have higher Gross Margins than others.

What is the Gross Margin formula?

• Gross Margin = (Total Revenue – COGS) ÷ Total Revenue X 100
• Revenue = Found on the income statement.
• Cost of Goods Sold = Found on the income statement.
• Gross Margin can be reflected as a percentage or a dollar value.
• The ratio indicates the percentage of each dollar of revenue that the company retains as gross profit.

How to use the GM ratio?

When searching for long-term compounders, it’s important to consider high Margins as they indicate a business’s efficiency. To identify companies with potential, look for those with higher margins compared to their peers or individual companies with sustained and growing margins. This can help narrow down the winners.

Different industries have widely different gross margins. We cannot compare a manufacturing business to a software or retailer in our comparison.  

GM Comparison

As an example let’s compare three companies in the same industry to identify one that is producing higher margins than its peers. If the industry benchmark has a Gross Margin average of say 50% we want to see if any of the companies are doing something different to produce above average results.

INCOME STATEMENT	Company A	Company B	Company C
Revenue	$550 million	$1.2 billion	$890 million
COGS	$178m	$680 million	$387 million
Gross Margin %	67.63%	43.33%	56.51%

So it means that Company A retained 67 Cents of each dollar of revenue after paying for COGS.

Our formula to show how it worked:

• Company A > ($550m-$178m) ÷ $550m x 100 = 67.63% OR (67 cents for every dollar)
• Company B > ($1.2b-$680m) ÷ $1.2b x 100 = 43.33% OR (43 cents for every dollar)
• Company C > ($890m-$387m) ÷ $890m x 100 = 56.51% OR (56 cents for every daollar)

It is all relative to industries and company size. If we are measuring apples for apples of a company against others in the same industry and it has a GM as Company A indicates, it usually is a sign the business is doing something different.

Shrinking Gross Margin

Let’s work out another example of a business that we find has a high margin and investigate whether A) it is rising and B) is it sustainable.

Income Statement	2021	2022	2023
Revenue	$550 million	$503million	$491 million
COGS	$178 million	$195 million	$202 million
Gross Margin %	67.63%	61.23%	58.85%

Shrinking Gross Margins can reflect a company losing its competitive edge as other businesses eat away at its margins. A major shift in margins may indicate mismanagement and rising operations costs and reflect a business not maximizing its resources. Creating a table when conducting deep research on an idea and seeing these numbers creates a visual of the company’s performance. We can see a decline in revenue and an increase in operational costs (COGS) resulting in a shrinking gross margin.

The questions we would ask are why is revenue declining and what is causing the operational costs to increase.

The opposite is true, a rising Gross Margin that is sustained over a few consecutive years is a great sign. Small fluctuations quarter on quarter are not of major concern, they can sometimes be representative of seasonal business and potential business improvements that have not flowed through to its margin.

As an example, a specialty retailer may have a quarter that has a lower Gross Margin than other quarters, it could reflect slower sales outside of key holiday seasons, however, the overall annual Gross Margin may remain high. Knowing these small changes can help ease your mind when earnings come out.

In Summary…

The more efficient production, the higher the margins. The higher the margins, the healthier the company. The gross margin shows if a business has control over its production costs.

A higher Gross Margin is ideal and something I look closely for; I am looking for above 50% meaning a business keeps half of every dollar after paying for costs. A business that improves its margin is doing so by either raising prices, improving its efficiency, lowering its cost of goods, or a combination of all of them. Sustaining a high gross margin can also reflect a durable competitive advantage.

The gross margin ratio needs to be used alongside other valuation metrics such as the Operating Margin to give a full picture of what is going on. The gross margin uses direct selling costs and does not consider other operational costs to keep the business ticking along.