Here’s why you need to watch gross margins as much as net margins

When looking at margins, gross margins are not typically considered by retail investors. But by considering them, you might gain an edge over investors who do not consider them. In this article, we articulate what gross margins are and outline what you need to look for, including what is a good rule of thumb to follow as for determining what is a good or bad level.

What are Gross Margins?

Gross margin measures the business’s profitability, taking into account the cost of goods sold (COGS), such as raw materials and labour. It represents how much of each dollar of sales a business keeps after paying for production costs. To calculate gross margin, you will need to subtract COGS from total sales and then divide the result by total sales.

Net margin measures profitability after taking all costs into account, such as overhead or administrative expenses, depreciation, interest on debt, taxes and any other operating expense. To calculate net margins you will need to subtract all of these expenses from your gross profit and then divide the result by total sales. When investors talk about margins, this is what they’re talking about. They’re not wrong to pay attention to net margins, but gross margins are important too.

To be clear, gross margins/profit is not alluding to EBITDA because EBITDA takes into account expenses not directly related to operations except of course depreciation, interest and tax. So marketing costs would be accounted for in EBITDA but not gross profit, because it is not a core part of operations. Gross margins only account for the core costs related to every day operations, rather than ‘side costs’.

Why are gross margins important?

Because they outline how profitable the core operations of a business is. Now, to be clear, you will almost always see a gross profit amongst businesses, even those with a negative EBITDA or NPAT.

However, the higher the gross margin is, the better the business’ core operations are. And as a consequence, you should watch gross margins to see if it is at a healthy level. If a company cannot even make a gross profit, it will not make a net profit. And even if it makes a gross profit, the net profit will not be high if the gross profit is not.

What investors need to look for

We think investors should, of course, watch gross margins. And specifically look for two things.

First, Although all industries are different, we think a gross margin over 50% is a good sign to see, indicating core operations are profitable. There’s no rule of thumb as to what is an good or bad  gross profit, although there may be some in certain industries. In our view, if a company has a gross profit that represents a margin below 30%, investors should reconsider whether or not they want to invest in the business.

Second, it is also good to see that there’s not a huge difference between gross and net profits.

If a company’s gross margin are 90% and net margins are barely 10%, this may be a sign a company is struggling to control costs. This is not a definitive sign, especially if has had a net profit for some time, but it foreshadows that there is a risk this could happen in the future. By monitoring these traits, investors can gain additional insight into their existing and potential holdings that other investors may not have. And therefore, they can make better decisions about which stocks to buy, hold and sell.

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