Calculating Gross Profit Margin
Investing Lesson 4 - Analyzing an Income Statement
By Joshua Kennon
Although we are only a few lines into the income statement, we can already calculate the gross profit margin, our first financial ratio. At its core, gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. It tells managers, investors, and other stakeholders the percentage of revenue / sales remaining after subtracting the cost of goods sold; the amount of money left over to pay selling, general, and administrative expenses such as salaries, research and development, and marketing, which appear further down the income statement.
All else equal, the higher the gross profit margin, the better.
This is especially true within industries and sectors because it's possible to make a better apples-to-apples comparison among competitors. A company capable of boasting sustained gross profit margins that are materially higher than its peers is almost always more efficient, better run, and a safer long-term investment provided the valuation multiple isn't too high. That last part may be a real concern due to the fact that investors (wisely, to some extent) are willing to pay up for quality, resulting in richer price-to-earnings ratios.
Finding the appropriate gross margin range for an industry is much easier these days than it was back when I first wrote this investing lesson roughly fifteen years ago. In a matter of seconds, you can pull industry reports from equity research analysts, rating agencies, statistical services, and other financial data providers, often much of which is given to clients of discount brokerage firms for free.
For example, Charles Schwab & Company, one of the largest brokers in the United States, has a deal with Swiss giant Credit Suisse. The firm's customers can download and read industry-specific financial reports which include gross profit margin calculations. Likewise, the firm also has data on specific companies from Thompson Reuters, which includes comparing a given company's gross profit margin with its direct and closest competitors in conveniently formatted charts.
How to Calculate Gross Profit Margin
Calculating gross profit margin is simple. The formula is Gross Profit ÷ Total Revenue.
Practice Exercise I - Calculating Gross Profit Margin for a Fictional Company
For illustrative purposes, let's calculate the gross profit margin of a fictional company called Greenwich Golf Supply. I've created its income statement, which you will find at the bottom of this page in Table GGS-1. For this exercise, we'll assume the average golf supply company has a gross margin of 30%.
We can take the numbers from Greenwich Golf Supply's income statement and plug them into our gross profit margin formula:
$162,084 gross profit ÷ $405,209 total revenue = 0.40, or 40%, gross profit margin
The answer, .40 (or 40%), tells us that Greenwich is much more efficient in the production and distribution of its product than most of its competitors. The next question you, as a potential investor, analyst, or competitor want to discover is, "Why?". What makes Greenwich so much more profitable? Does it have a source of low-cost inputs? If so, is it sustainable? For example, you see this with airlines from time to time as certain airlines hedge the price of fuel before it skyrockets, allowing these firms to generate much higher earnings per flight than competitors but the benefit is limited because those hedging contracts expire, making it more of a one-time, temporary but lucrative boost in profitability.
Practice Exercise I - Calculating Gross Profit Margin for a Real Company
Recently, I have been writing about Tiffany & Company, one of the world's premier jewelry stores. Since its IPO more than 25 years ago, it has made its long-term owners exceedingly wealthy. The full fiscal 2015 year hasn't closed, so we'll need to look at 2014's numbers since that was the last complete year on record. The typical jewelry store generates gross profit margins of between 42% and 47%. How does Tiffany & Co. compare?
For the period in question, gross profit was $2,537,175,000 and sales were $4,249,913,000. Putting this in the gross profit margin formula, we discover that Tiffany enjoys mouthwateringly high margins of 59.7% [ $2,537,175,000 ÷ $4,249,913,000 = 0.597, or 59.75%]. It is ?far more efficient than its competitors, able to convert more of each dollar in sales into a dollar of gross profit that can be used to build the brand, expand, and compete against other firms, creating this sort of self-reinforcing, virtuous cycle for shareholders.
When you dig deeper into the 10-K filing, you discover that this is due in no small part to 1.) it's ability to generate much higher sales per square foot than other jewelry stores ($3,100 per square foot versus $1,035 per square foot for competitor Signet Jewelers, which operates Kay jewelers, Zales, and Jared jewelry stores), and 2.) its size and scope allows it to gain economies of scale in the manufacturing and distribution of its jewelry products.
Be Sure To Watch a Firm's Gross Profit Margin Over Time
The gross margin tends to remain stable over time. Significant fluctuations can be a potential sign of fraud, accounting irregularities, mismanagement, secular declines in the business itself, or, if positive, a turnaround, expansion, or product mix shift that has rewarded owners such as the one the Apple experienced after the return of Steve Jobs several decades ago. If you are analyzing the income statement of a business and gross margin has historically averaged around 3%-4%, and suddenly it shoots upwards of 25%, it should warrant serious investigation. Perhaps it is entirely legitimate but you want to know exactly where, how, and why that money is being generated.
Let's use Tiffany & Company, again, to demonstrate the importance of gross margin stability since I already have the annual report open in front of me. Here are the results for a five year period:
- 2010 gross profit margin = 59.1%
- 2011 gross profit margin = 59.0%
- 2012 gross profit margin = 57.0%
- 2013 gross profit margin = 58.1%
- 2014 gross profit margin = 59.7%
This is all very good. There's nothing out of the ordinary.
For more advanced readers who own a business or want to understand how to analyze gross profit margins for companies in which they wish to buy stock, I wrote an essay called A Deeper Look at Gross Profit and Gross Profit Margins explaining how it is possible for a company with low gross profit margins to make more money than a company with high gross profit margins. It is definitely worth reading if you desire to master this topic.