I cover gross margins in my book, “The Rules of Super Growth Stocks Investing”, section 4-2. But without discussing its importance, the purpose of this article is to explain why gross profit is so important to a business. And why does the management team play a role in gross margin.
Wouldn’t the ROE be better?
Indeed. But have you ever thought about it? Many US-listed companies are losing money. How can they calculate the return on equity (ROE) without positive earnings? However, most listed companies must have turnover and can calculate the gross margin.
Over the past 12 months, more than 1,600 S&P 1500 and S&P Completion companies have lost money. This means that 41% of companies lost money during this period. That’s down slightly from the 2020 COVID-19 pandemic. In 2020, half of listed companies lost money. Note that these two indexes are all larger companies, and if the entire U.S. stock market were sampled, the proportion would rise by a lot.
You can refer to my previous blog post “ROE, the most important management indicator“.
How to calculate gross margin
Gross profit rate = (operating income-operating cost) / sales income × 100%
The calculation of gross profit is simple; it is operating income minus operating costs. It can be seen from the algorithm that there is only one factor that determines gross profit-that is, operating costs, there are no other factors between revenue and gross profit (this is very important). Don’t forget that operating income is the only trustworthy and unchangeable figure in the financial report. It is the source of all figures in the financial report. The figures in other financial reports are calculated from this. Therefore, operating costs can be kept down and gross profit margin can be increased.
Why does gross profit margin have a great relationship with the management team? Because the biggest factor in determining the gross profit rate of a company is the industry in which the company is located – “The level of gross profit margin represents the competitiveness of the company’s products.” Therefore, if the gross profit margin is significantly higher than that of its peers, the company’s “basic” costs will be controlled.
If it is matched with other “derived” operating profit margins, earnings before interest and taxes (Earnings Before Interest and Taxes, EBIT), Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), and net interest rate. Then through various cost control and legal financial adjustments, the final earnings per share (EPS) can be increased. Having high earnings per share, of course, can increase the price-to-earnings ratio, the company’s market valuation, and push up the company’s stock price.
The impact of gross profit on the business?
Companies with high gross profit margins will be in a more favorable position in terms of long-term business performance. This is because:
- A higher gross profit margin enables the company to maintain a stable business level, which is conducive to the long-term operation of the company and the adjustment of its development direction; that is, it can ensure the continuity of the company’s operations.
- A higher gross profit margin can expand the scale of profit and the performance of operations. Without better gross profit, a higher profit margin cannot be guaranteed.
And generally speaking, large companies have a great advantage in driving gross profit margins. This is because:
- Large companies have a larger revenue base, which affects the total gross profit. The larger the total amount, the more profit that can be used.
- Operating profit is the result of total operating expenses deducted from gross profit.
The above factors involve all the links of the company, and cannot be solved by a single financial project or department; this is why I say: the ability and performance of the enterprise management team can be seen from the gross profit margin, because this is a cross-department It takes courage to execute.
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