Why Investors Should Pay Attention to Gross Margin

Key Takeaways

• Expressed as a percentage, gross margin is the amount a company makes after factoring in the cost of doing business.

• Investors and analysts use the metric to determine how well a company turns sales into profits.

• The chief difference between net margin and gross margin is net margin includes operating expenses, taxes, and interest.

Gross margin offers deep insights into a company’s financial health, operational efficiency, and profitability. As such, it is a crucial metric for investors and companies alike.

By comparing gross margin ratios, investors can assess how well a company manages its production costs relative to its sales revenue. This is markedly important information for making informed investment decisions.

Here is more about why investors should pay attention to gross margin.

Exploring Gross Margin Ratio

Gross profit margin ratio, also known as gross margin ratio, is the percentage of revenue representing gross profit. 

Expressed as a percentage, gross margin is the amount a company makes after factoring in the cost of goods sold (labor and materials, excluding overhead costs).

Investors and analysts use the metric to determine how well a company turns sales into profits. Companies also use gross margin to monitor the effectiveness of some products or services when compared with others. So, it is quite an important tool.

Most companies usually maintain a steady gross profit margin. If the ratio goes up or down at an atypical clip, it could spell problems. For example, there could be issues with the company such as increased costs for raw materials or difficulties with product distribution.

There are a couple of ways to arrive at gross margin, but the quick formula is Gross Margin Ratio = (Revenue – Cost of Goods Sold) / Revenue.

For example, Christine has a cosmetics business with total sales of $1.2 million and a cost of goods sold (COGS) of $450,000. The rent is $300,000, her utilities come to $20,000, and accrued expenses amount to $5,000. The company’s gross profit margin is 62.5%, meaning that for every dollar of sales produced, the company profit 62.5 cents.

Gross Margin Ratio =

$1,200,000 – $450,000

——————————- = 62.5%

$1,200,000

Gross Margin vs. Gross Profit

Many people confuse gross margin and gross profit, which are both derived from income statements but show profitability differently. Gross profit is total revenue minus the cost of goods sold. The difference, then, is that gross margin expresses gross profit as a percentage of revenue. Generally, the higher, the better. A low margin indicates room for improvement.

While the two metrics are complementary, the margin (the percentage form) offers more insight than the absolute figure (gross profit). That is because it permits comparisons across goods or services, as well as periods and projections.

Gross Margin vs. Net Margin

Then there is net margin, which is Net Income / Revenue and also expressed as a percentage. Simply put, net margin is the ratio of its net profit to its revenues.

Both margins are used to assess how well a company is generating profits. The chief difference between net margin and gross margin is that the former includes operating expenses, taxes, and interest. Thus, gross margin amounts to a more conservative number.

Both profitability ratios are crucial but serve different analytical purposes. For example, a company can use its net profit margin to discover inefficiencies. It can also determine the effectiveness of its current business model.

What is a Good Gross Profit Margin?

What is considered a “good” gross profit margin varies by industry. A practical way to determine a favorable gross profit entails comparing a company’s percentage to sector averages. Even then, the company’s broader strategies and goals should also be factored in.

A challenge in evaluating whether a company has achieved a positive gross profit margin is the amount of variance that exists across varying industries. 

Overall, the national average is 36.22%. However, the margin for regional banks is 99.75%, and just 9.04% for automotive companies, for example. Service industries tend to report higher margins because their COGS is significantly lower,

Sector-wise, other recent gross profit margins include:

• Advertising 23.99% 
• Apparel 49.77%
• Building materials 23.38%
• Computer services 27.16%
• Home furnishings 27.03%
• Healthcare products 56.94%
• Household products 50.87%
• Machinery 34.50%
• Packaging and container 22.39%
• Precious metals 50.17%
• Recreation 37.58%
• Restaurants and dining 27.60%
• Retail (general) 24.27%
• Retail (online) 42.53%
• Software (Internet) 58.58%
• Transportation 19.91%

Specific sectors notwithstanding, higher margins typically indicate better efficiency and profitability. To more thoroughly assess a company’s competitiveness and overall financial health, it is advisable to use other metrics such as free cash flow, leverage ratios, and hard costs versus soft costs, in addition to gross profit margin.

How to Calculate Gross Margin Percentage 

To calculate gross margin, subtract from the company’s revenue the cost of goods. This will yield the company’s gross product. That figure is then divided by total revenue and multiplied by 100. That figure is the gross margin.

Note the importance of having accurate “cost of goods sold” and revenue numbers. COGS refers to the amount a company pays to produce the goods it sells. Included in this amount is the cost of the labor and materials used to create the product. It leaves out indirect expenses such as sales force and distribution costs.

Say an area shoe manufacturer recorded net sales of $500,000 over the last 12 months. It had outlays of $100,000 for materials and $200,000 for labor, amounting to $300,000 in cost of goods sold. When the percentage gross margin formula is applied, the gross margin percentage is 40%.

• ($500,000 – $300,000) /$500,000) *100

• ($200,000/$500,000) *100

• 0.4*100

• 40%

Diversification 

For investors, gross margin is a key measure as it allows them to make decisions about an organization without necessarily having to perform a lot of research about them. 

Meanwhile, investors in alternative assets can generally avoid use of the metric, and diversify their portfolio, to boot. Increasingly, they are adding private-market alternative assets — those other than stocks, bonds, or cash — to their holdings.

Due to their low correlation to public markets, alternative assets such as art and real estate are less volatile. Private markets have also performed better than the stock market during every downturn of the last 15 years.

Going through one of the leading alternative investment platforms, Yieldstreet, on which $4 billion has been invested to date, offers the added benefit of scrutiny. While no investment is without risk, Yieldstreet’s offerings go through a rigorous vetting process before reaching the platform. Most potential opportunities do not make it.

Ultimately, investment portfolios that contain a mix of asset types can mitigate overall risk. Diversification can also potentially guard against inflation and potentially improve returns. In fact, it is key to long-term investing success.

Alternative Assets and Portfolio Diversification 

Alternatives can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other  alternative investments.

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary 

Gross margin is an essential tool for gauging a company’s financial stability, with higher margins usually indicating better efficiency and profitability. Low numbers could mean the company is experiencing losses on production. In any case, investors can use this knowledge to evaluate investment opportunities more effectively.

Note, though, that when comparing gross margins, it is important for investors to do so within the same industry. For a more holistic view of a company’s financial health, it is advisable to use other metrics as well.

Remember, too, that alternative assets are generally more stable than those correlated with public markets and can provide all-important portfolio diversification.