Wednesday, 28 March 2018

Gross Profit Margin: Key numbers for Warren in his search for long-term gold.

3 Quick Tests for a Business with a long-term Durable Competitive Advantage:

1.   Earning Test
2.   Return (Profit) Test and
3.   Debt test.

2. Return (Profit) Test


                  Income Statement

  ($ in millions)

 -> Revenue
     Cost of Goods Sold
-> Gross Profit


    Gross Profit $7,000 / Revenue $10,000 = Gross Profit Margin 70%

Now if we subtract from the company's total revenue the amount reported as its Cost of Goods Sold, we get the company's reported Gross Profit. An example: total revenue of $10 million less cost of goods sold of $3 million equals a gross profit of $7 million.

        Gross profit is how much money the company made off of total revenue after subtracting the costs of the raw goods and the labor used to make the goods. It doesn't include such categories as sales and administrative costs, depreciation, and the interest costs of running the business.

By itself, gross profit tells us very little, but we can use this number to calculate the company's gross profit margin, which can tell us a lot about the economic nature of the company.

The equation for determining gross profit margin is:

Gross Profit / Total Revenues = Gross Profit Margin

Warren's perspective is to look for companies that have some kind of durable competitive advantage---businesses that he can profit from over the long run. What he has found is that companies that have excellent long-term economics working in their favor tend to have consistently higher gross profit margins than those that don't.

Let me show you:

The gross profit margins of companies that Warren has already identified as having a durable competitive advantage include: Coca-Cola, which shows a consistent gross profit margin of 60% or better; the bond rating company Moody's, 73%; the Burlington Northern Santa Fe Railway, 61%; and the very chewable Wrigley Co., 51%.

Contrast these excellent businesses with several companies we know that have poor long-term economics, such as the in-and-out-of-bankruptcy United Airlines, which shows a gross profit margin of 14%; troubled auto maker General Motors, which comes in at a weak 21%; the once troubled, but now profitable U.S. Steel, at a not-so-strong 17%; and Goodyear Tyre---which runs in any weather, but in a bad economy is stuck at a not-very-impressive 20%.

In the tech world---a field Warren stays away from because he doesn't understand it---Microsoft shows a consistent gross profit margin of 79%, while Apple Inc. comes in at 33%. These percentages indicate that Microsoft produces better economics selling operating systems and software than Apple does selling hardware and services.

What creates a high gross profit margin is the company's durable competitive advantage, which allows it the freedom to price the products and services it sells well in excess of its cost of goods sold. Without a competitive advantage, companies have to compete by lowering the price of the product or service they are selling. That drop, of course, lowers their profit margins and therefore their profitability.

As a very general rule (and there are exceptions): Companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage. Companies with gross profit margins below 40% tend to be companies in highly competitive industries, where competition is hurting overall profit margins (there are exceptions here, too). Any gross profit margin of 20% and below is usually a good indicator of a fiercely competitive industry, where no one company can create a sustainable competitive advantage over the competition. And a company in a fiercely competitive industry, without some kind of competitive advantage working in its favor, is never going to make us rich over the long run.

While the gross profit margin test is not fail-safe, it is one of the early indicators that the company in question has some kind of consistent durable competitive advantage. Warren strongly emphasizes the word "durable," and to be on the safe side we should track the annual gross profit margins for the last ten years to ensure that the "consistency" is there. Warren knows that when we look for companies with a durable competitive advantage, "consistency" is the name of the game.

Now there are a number of ways that a company with a high gross profit margin can go astray and be stripped of its long-term competitive advantage. One of these is high research costs, another is high selling and administrative costs, and a third is high interest costs on debt. Any one of these three costs can destroy the long-term economics of the business. These are called operating expenses, and they are the thorn in the side of every business.

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