Gross Profit Margin: What Does It Tell Investors?
Profit is the most important goal of any company. It does not matter how much revenue a company generates if it is not able to eventually turn a profit. Yes, some companies are willing to forgo profits in the near-term for future growth, but the final goal is and always will be to earn money and keep it.
As such, measuring a company’s profitability should be of the utmost importance to any investor. The success of a business, and ultimately, the investment is dependent on it. With that, I would like to discuss one key aspect of measuring the profitability of a company – the gross profit margin.
But first, what is gross profit margin?
Gross profit margin is the ratio of gross profit to revenue. Gross profit is the profit a company makes after deducting the costs incurred in making and selling its products. It does not take into account other expenses.
Gross profit margin should not be confused with net profit margin which takes into account all other expenses of the business.
Why is gross profit margin important?
The gross profit margin of a company tells investors how efficient a company is in the production phase of the business. It can also give us an insight into the pricing power of a firm.
Companies that have a high gross profit margin can price goods high and yet, maintain customer appeal.
It is also crucial for a company to have a high gross profit margin so that it has the leeway to pay off other expenses and still maintain a sizeable profit at the end.
Limitations of using gross profit margin
As informative as it is, the gross profit margin does not tell the overall story of the company. It is, therefore, important to use other information to further understand the business of the company.
Investors should also be aware that there are companies that are willing to forgo high margins in the hope of larger future profits. Their low profit margins may not be a true indicator of the company’s health.
Another point to note is that some companies forgo profit margins for greater profits. One good example is the fast food industry. They typically operate on a much lower margin than other restaurants. We are also all probably familiar with the “up-size your meal” system. The upsized portion of the meal is charged at much lower price than the actual meal itself, resulting in much lower gross profit margins for this sale. Fast food companies are not fussed about the lower margins as long as they are able to turn a larger profit in the end.
The Foolish bottom line
The gross profit margin of a company can tell us many things about its business. It can be an indicator of pricing power and production efficiency. At the same time, we should not use it in isolation as there are other factors to consider too. It is also important to note that different industries may operate with different margins. Because of this, we should only compare gross margins between companies within the same sector and not across various industries.