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Investors usually buy companies they believe will make money, preferably lots of money at the lowest possible cost to the business.
Knowing that a company earns oodles of money selling gadgets or gizmos isn’t enough, though. Investors need to know how much it costs to make those sales, for instance, in the form of purchasing inventory or production. To understand that relationship and compare profitability to the past and to other businesses in the industry, you need to look at a ratio called gross profit margin.
The gross profit margin looks at revenue from sales, subtracts the cost of those sales and distills the information to a percentage.
Gross profit = Sales – Cost of sales
Gross profit margin = Gross profit / Sales
To find this top line information, investors turn to the financial statement. Publicly traded companies release quarterly earnings, plus an annual report. The revenue and sales information is found on the income statement.
Here’s a look at Apple’s income statement from the 2014 annual report.
Apple (ticker: AAPL)
Consolidated statements of operations (in millions)
|Years ended||Sept. 27, 2014||Sept. 28, 2013||Sept. 29, 2012|
|Cost of sales||$112,258||$106,606||$87,846|
|Gross profit margin||$70,537||$64,304||$68,662|
Gross profit margin looks only at the impact of the cost of sales on revenue, before all the other expenses of running the business are accounted for. Expenses such as marketing and administrative costs aren’t included in cost of sales.
There are other profitability ratios: operating profit margin, net profit margin and pretax profit margin.
Comparing the gross profit margin of disparate or vaguely similar businesses won’t tell you much.
“If you have 2 businesses, looking at Wal-Mart versus Tiffany for example, you would expect Wal-Mart’s gross profit margin to be much smaller than Tiffany’s. It doesn’t mean Wal-Mart won’t make more money. They may be a volume business, pay their people less, have less expenses, have more stores, pay less expensive rent,” says Keith Lanton, president of Lantern Investments in Melville, New York.
Target Corp. would provide an apples-to-apples comparison for Wal-Mart.
“Gross profit is very industry specific,” says Robert R. Johnson, Ph.D., CFA, president and CEO of the American College of Financial Services in Bryn Mawr, Pennsylvania.
“For instance, Coca-Cola’s gross profit margin is around 60%. On the other hand, the grocery industry is characterized by much lower gross profit margins. Kroger has a gross profit margin of around 22%. That doesn’t mean Coca-Cola is a better business than Kroger. What it means is that each has fundamentally different business models,” he says.
A gross profit margin that decreases over time would be something to note, as would profits dramatically below those of a similar firm.
“That may be a cause for concern,” Johnson says.