Gross profit margin is one of the three main margins formulas in a company’s income statement which measures a company’s efficiency in creating profitability.
Gross profit margin, or “Gross Margin”, is basically how profitable a product or service is, before you account for the operating costs, taxes and interest payments to run the business.
This formula can be useful for uncovering if a company has a competitive advantage, more on that later.
To get a good sense of what makes a good gross margin, we will examine the average gross profit margin by industry over 20 years of data from the S&P 500. It’s not always the absolute gross margin which is most important when looking at this formula, but rather a comparison between peers.
This post will cover:
- The Basics of Gross Profit Margins
- Finding Gross Margin in the 10-k (Real Life Examples)
- Evaluating Companies Based on Their Gross Margins
- The Sustainability of Gross Margins
- Average Gross Profit Margin By Industry [S&P 500]
Alright, let’s take a deep (and important!) dive into gross profit margins and their prominent place in every company’s income statement/ P&L.
The Basics of Gross Profit Margins
To calculate gross margin, start at the very top of the income statement:
Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
This number will be a percentage, where the higher the percentage the more profitable a company is on delivering their goods or services.
You can also think of the formula in the following way:
Gross Profit = Revenue – Cost of Goods Sold
Gross Profit Margin = Gross Profit / Revenue
Simply calculating a company’s gross margin can differ depending on the industry; sometimes instead of “Cost of Goods” you’ll see “Cost of Sales”.
The important number to hone-in on is the first profit metric after top-line expenses are taken out. Any income statement will have 3 profit metrics, which correspond with the 3 margins formulas:
- Gross Profit
- Operating Profit
- Net Profit Income
The easiest to remember is that gross is at the top, and again is the measure of how much it costs a company to provide a good or service. It is profit after Cost of Goods Sold or Cost of Sales.
For a manufacturer who produces goods, Cost of Goods Sold will include expenses such as the labor in a factory and the costs of materials to create the product.
For a service-based business, Cost of Sales will include expenses like the labor required to serve the customer; a restaurant might have its wait staff and rent as part of Cost of Sales.
However, gross profit is before operating profit, which does not account for the expenses required to operate the business. Operating expenses include things like:
- Selling and marketing
- General and administration
- Research and development
Selling and marketing is also called “SG&A”, and so another easy way to identify the Gross Margin is to look for the profit number above SG&A-type expenses. (Note that Depreciation and Amortization is also included in Operating Profit/Income).
Finding Gross Margin in the 10-k (Real Life Examples)
Let’s take two examples of gross profit margin in a (real) company’s financial statements, through their publicly filed annual report (or “10-k”).
The first I’d like to look at is a more typical manufacturer of tangible goods; let’s start with semiconductor producer Texas Instruments. I like using the free website bamsec.com to quickly pull up a company’s financial documents.
Scrolling down to the company’s Consolidated Statements of Income for their latest 10-k, we can quickly find the Revenue and Cost of Revenue at the top:
You can see that Gross Profit is clearly displayed here, with its value being the difference of Revenues subtracted by Cost of revenue (COR).
Our gross profit margin then is:
= Gross Profit/ Revenue
= 9,269 million / 14,461 million
As we’ll see later that’s a pretty high gross margin, and it speaks to the wide profits currently available for the critical, high tech semiconductors which are such a large part of the goods economy today.
Let’s take another example, this one from the consulting business. Here’s a company called Booz Allen Hamilton ($BAH), they provide consulting to the government, and the income statement from their latest 10-k:
We can see that Gross Profit is not explicitly expressed in this 10-k, so we must make our own calculation.
Usually, if I were to see a company like this, I would just take Cost of Revenue and subtract that from Revenue to get Gross Profit.
But we can see a unique expense that the company calls “Billable expenses”. This is due to the nature of their contracts being serviced to various U.S. government entities.
To make a good estimation on whether billable expenses should be included in Gross Profit or Operating Profit, we should look at some of its peers and their financial statements. Unfortunately, $BAH doesn’t expressly list their competitors in the annual report either, so we’ll have to do some digging.
Using the EDGAR Full Text Search to find instances where other companies mention “Booz Allen Hamilton” in their 10-k’s, I found a company who considered themselves to be direct competitors to $BAH, a company called Atlas Technical Consultants. Unfortunately, they don’t mention any billable expenses, but let’s do more digging.
Another competitor listed by Atlas Technical Consultants was Huron Consulting Group, and their income statement looked like the following:
After understanding the nature of these contracts, we can understand that billable expenses and reimbursable expenses are essentially the same thing. We see that the company includes reimbursable expenses in their revenues and then subtracts it from revenues, with expenses reporting slightly higher and implying the company went slightly above the amounts allotted from its clients for those type of expenses.
Noting this difference, if we want to take an apples-to-apples comparison of gross profit margins between $BAH and $HURN, it’s probably better to use revenues net of billable/reimbursable expenses rather than treat billable expenses as an operating expense.
In other words, part of $BAH’s revenue should include the compensation from “billable expenses”, which do appear to be required as part of delivering the service (defined as “direct subcontractor expenses, travel expenses, and other expenses incurred to perform on contracts” in the 10-k).
So, for $HURN we’d calculate gross profit as:
= Total revenues – Direct costs – Reimbursable expenses
= 871,014 – 592,428 – 26,918
= 251,668 thousand
And then gross profit margin as:
= Gross Profit / (Toral revenues and reimbursable expenses – Reimbursable expenses)
= 251,668 / (871,014 – 26,918)
For $BAH, taking a similar approach and essentially adjusting revenue for the billable expenses, gross profit would be:
= Revenue – Cost of Revenue – Billable expenses
= 7,858,938 – 3,657,530 – 2,325,888
= 1,875,520 thousand
With the gross profit margin, again adjusting our top line revenue to net out the billable expenses:
= Gross Profit / Net Revenue
= Gross Profit / (Revenue – Billable expenses)
= 1,875,520 / (7,858,938 – 2,325,888)
Let’s keep in mind that $BAH considers “Billable expenses” to be an operating expense rather than direct Cost of Revenue expense which has a big impact on an estimation of Gross Profit.
Management and/or analysts might have better reasoning to why this is the case rather than not, in which case the company reports Gross Margins above 50%; my point is that a good analysis of gross margin should require a judgment call especially if comparing to peers when some metrics have the possibility of not being 100% clear.
Evaluating Companies Based on Their Gross Margins
Now that we know how to calculate gross profit margin, it’s time to think about the implications of the metric.
First of all, it’s obvious that the higher gross margins are better. Higher gross margin means lower expenses, which will flow down the income statement to influence higher operating margins and net margins, making its way all the way to the cash flow statement for higher free cash flow margins.
But, just because a company has a higher average gross margin doesn’t mean it is automatically a better investment than another.
For one, we want to make sure we are comparing gross margins between peers.
Comparing the gross margin of a thin margins retailer like Target to a capital light software company is not fair and tells us nothing about the attractiveness of an investment.
Target’s thin gross margins could actually be a competitive advantage in its industry if they are higher than peers (such as a TJ Maxx), because it would theoretically allow the company better profitability on a similar volume/sales, which could allow it to be more aggressive in marketing or simply return more cash to shareholders.
However, a comparison between peers assumes companies are going after the same market or products/services. Telling us the gross margin difference between Target and Costco is less relevant because they are mostly playing two different ballgames (Costco selling low prices and items in bulk on a membership program versus Target’s on-trend merchandise).
While it’s true that higher gross margins will tend to lead to higher valuations due to it likely flowing down to high return on capital metrics like ROIC, good investments require the right mix of low enough valuation and high compounding of capital to create great returns over the long term.
The Sustainability of Gross Margins
One attractive feature of calculating gross margins is that, according to the data, companies with high gross margins are likely to sustain those over the very long term.
There’s a fantastic report by Michael Mauboussin called The Base Rate Book which looked at how reliable past financial metrics were in predicting future performance.
A few surprising takeaways were that past revenue growth was generally NOT indicative of future revenue growth; future revenue growth was pretty random. On a scale of 0-1, with 0 being completely random and 1 being a perfect correlation, revenue growth scored 0.30 on a 1-year time horizon, 0.17 on a 3-year, and 0.19 on a 5-year.
This means that when they say, past performance is not a guarantee of future results, this is especially true for high revenue growth rates!
Compare this with the high correlation in gross profitability. In this case, high gross profit margins were sustained more in some industries than others, but each found to have much higher (5-year) correlations than something like historical revenue growth.
- Consumer Staples = 0.86
- Industrials = 0.79
- Health Care = 0.77
- Consumer Discretionary = 0.77
- Materials = 0.76
- Information Technology = 0.63
- Energy = 0.61
- Telecommunication Services = 0.59
This means that calculating gross margins for potential investments is likely to be a very worthwhile experience, and that companies with sustained higher gross margins than peers are more likely to sustain those moving forward—whether because of inherent competitive advantages or otherwise.
Operating margin had a similar high correlation over 5-years, which the following results by industry:
- Consumer Staples = 0.89
- Health Care = 0.74
- Consumer Discretionary = 0.73
- Industrials = 0.72
- Telecommunication Services = 0.63
- Materials = 0.62
- Information Technology = 0.62
- Energy = 0.62
Along with revenue growth Mauboussin found that Earnings growth had similar poor correlations, and so it may shed light on why more focus should be applied to Gross and Operating Margins rather than Net Margins most of the time.
Christopher Mayer also offered in his great book 100 Baggers that Gross Margins are more likely to be indicative of a competitive advantage than Operating Margins, especially because Operating Margins can be more easily improved by cutting the operational fluff of a business.
These are all great insights to keep in mind when looking at these profitability metrics.
Average Gross Profit Margin By Industry [S&P 500]
To examine the historical data for the 500 companies in the S&P, I used the current constituents as of July 19, 2021, all the way back to 2001.
Because many companies have been subtracted from the index since that time, there is some survivorship bias with this data. However, it serves a good purpose for this post, in that we are getting a general sense of what some average gross margins look like across the market in today’s times.
Here’s the data separated by sector:
The data makes a lot of sense for the most part. We would assume that Communication Services, which includes social media and video game companies, should have higher gross profit margins than a very capital intensive one like Energy.
Maybe surprising was the higher gross margins in financials and healthcare, with the average sitting around 45% across the entire market.
Energy, industrials, and materials have very low gross margins and this has been reflected for many years with their lower valuations. The other sectors seem to hover close to the average, with some even crossing above 70% in previous years (which could have something to do with the survivorship bias of the data).
Now I’ll take the same data and group the average gross profit margin by industry for each of the 20 years between 2001- 2020, shared in this table:
Hopefully that data is clear enough to read if you click to zoom on the table.
All-in-all, gross margin is a fantastic tool towards helping to understand a company’s business model and their ability to create profits from the products/services they offer.
Combining it with an understanding of operating margin can help you find businesses which excel at what they do, and hopefully provide great investment opportunities for the decades to come.