The Importance of Gross Profit
In order to find the fair value of common stock, we need to determine the net profit generated by the firm. The breakdown of the income statement will give us the steps needed to find a net profit. One of the key components of the income statement is gross margin
What is gross profit? Gross margin is the profit after deducting all variable costs. For a retailer, it is the difference between the selling price of the item and the price of the item purchased by the company. In other words, the difference between its sales and its buying
Gross margins alone can not give us much information about the strength of an enterprise. Gross margin is usually expressed as a percentage. This is called gross margin (GPM). Gross margin in different industries are different. Retailers typically have lower gross margins than software companies
So, how do investors use gross margin to analyze companies? Investors can use this tool to explain the company's competitiveness. By analyzing gross margin trends, you can determine the health of specific companies. Gross margin is only three trends. Gross margin can go up, down or stay the same. I will explain the implications of these two trends
Increase gross profit This is never a bad thing when companies can increase their gross margins. Increasing gross margin means two things for the company. First, the company has better pricing power. When the company to raise prices because of overwhelming demand, the gross margin will rise. Of course, this assumes that the variable cost does not increase. Second, increasing gross margins could mean companies are more productive. Gross margin will increase when unit prices remain constant while variable unit costs decline.
Gross margin declined. Gross margin decline is not conducive to the company. This usually means two things. First, it could mean that variable costs rise as a result of changes in commodity prices. When the selling price remains unchanged, and variable costs increase, the gross margin will decline. Second, the decline in gross margin also means that the company has no pricing power. This is not a good thing when companies have to cut prices to generate sales. When the unit sales price decreases while the variable cost remains constant, the gross margin will decrease
When estimating the gross margin for the fair value calculation, we need to consider other factors such as industry competitiveness, company inventory level
For example, when a company's inventory level is high, the gross margin will eventually be damaged. The reasoning is that when you have too many unsold items, you have to sell it at a lower price (cut) to clear your inventory.
Estimating a reasonable gross profit margin is critical to determining the fair value of your investment. If Company A has a gross margin of 20% in its history, it would be a good idea to have a gross margin of 60% next year. Perhaps a new patented product will be released. Or, its biggest competitor may just close the door, thus allowing the company to raise prices. Whatever it is, it is important for investors to know what causes the gross margin to change.