[mainbodyad]As I explained in my investing lesson on how to read an income statement over at About.com, a division of The New York Times, gross profit and the gross profit margin are both important because they determine how much money out of each dollar sold is available for salaries, benefits, advertising, expansion, debt reduction, and dividend payments to shareholders. But too often, managers and investors obsess about high gross profit margins because they think that is the goal of a business.
You need to understand something about accounting and finance to see why this isn’t necessarily true. This is going to get into some complex breakdowns of company profitability so it isn’t even remotely appropriate for beginners. I’ll try to make it as simple as possible, though, so you understand how the various components of return on equity (re: return on book value) interact.
Gross Profit and Gross Profit Margins Are Not All Important
Gross profit and gross profit margin cannot be your all-obsessive focus because they are only part of the two financial ratios that matter more than any others: return on equity and return on assets. It is possible for a company with 20% gross profit margins to be more profitable than a business with 80% gross profit margins. That may seem crazy but it has to do with breaking down the individual components of the return on equity (ROE) figure.Back in 1919, a financial executive at DuPont discovered how to segregate the individual components of return on equity. Today, we call his approach a DuPont ROE analysis (I wrote about the specifics in DuPont Analysis of Return on Equity at About.com). Getting into that is another essay for another day but the bottom line is a company that turns its assets more frequently can generate more absolute profit relative to the capital invested in the enterprise than one with slower turnover but higher profit margins.
Think of it this way: If you had two guys selling chocolate bars and John earned 5 cents per chocolate bar and Gary earned 10 cents per chocolate bar, common sense tells you that the John must sell 2x as much candy just to make as much profit as Gary.
But if John attracts a lot more customers than Gary due to his incredibly low prices, he can make more absolute profit even though he has smaller gross profit margins. That is, if John sells 100 candy bars and earns $5 (100 bars sold x $0.05 gross profit per bar = $5.00 total gross profit) and Gary only sells 25 bars (25 bars sold x $0.10 gross profit per bar = $2.50 total gross profit), John made twice as much money even though Gary’s gross profit margins were double his own!
Gross Profit Margin Business Models at Wal-Mart and Microsoft
In real life, let’s look at the gross profit margin business models of Wal-Mart vs. Microsoft. It will help you understand this concept.
The Low Gross Profit Margin Business Model: One of the ways Wal-Mart was able to achieve 60%+ returns on equity for decades was by focusing on high asset turnover and low gross profit margins. Sam Walton was obsessed with asset turnover and he used a good deal of leverage to expand the real estate portfolio, as well, more than overcompensating for the fact that his gross profit margins were a fraction of those earned by his competition. That is one of the reasons his private family investment company, Walton Enterprises LLC, is worth more than $90 billion today. Of the $408.214 billion in revenue Wal-Mart generated in fiscal year ended January 31, 2010, $103.557 billion was gross profit for 25.37% gross profit margins.
The High Gross Profit Margin Business Model: Microsoft, on the other hand, generates gross profit margins that are staggering. Of the $62.484 billion in revenue it generated in fiscal year 2010, $50.089 billion of was gross profit. That is a gross profit margin of 80.16%.
Now, if you really want to be surprised, think about the fact that Microsoft – which earns gross profit margins of 80.16% or $50.089 billion per year – makes more net income than Wal-Mart, which made $103.557 billion in gross profit with its 25.37% gross profit margins.
The reason? Selling, general and administrative expenses. Wal-Mart requires a global network of stores that need associates, electricity, running water, insurance, parking lots, shelves, and more. Microsoft needs a single campus in Washington state before it distributes products electronically or before it ships them to retailers. This involves the operating profit margin, which I’m not going to get into now.
A Summary of the Gross Profit Margin Analysis
[mainbodyad]This is what makes business fun:
- Microsoft has a gross profit margin of 80.16% vs. Wal-Mart’s 25.37%
- Wal-Mart makes gross profits of $103.557 billion, which is more than twice Microsoft’s gross profits of $50.089 billion, because Wal-Mart’s revenues are much, much higher than Microsoft’s.
- Microsoft makes more net income ($18.76 billion) than Wal-Mart ($14.335 billion) because it doesn’t require a lot of fixed expenses to do business.
Do you see now why you can’t obsess about gross profit margins? You need to decide on the business model your company is pursuing and then stick with it as long as it works. That means someone at Wal-Mart shouldn’t be thinking about how to increase gross profit margins if it comes at the expense of asset turns because that could endanger the high return on equity the firm has achieved since being founded in the 1960’s. Likewise, it makes no sense for Microsoft to try and get more volume turnover by lowering prices – if you want Microsoft Office, you probably bought it on launch day or as part of a new computer.
That doesn’t mean you can’t offer gross profit margin sweeteners. I know of one popular apparel company that offers tiny add-on options that have 90%+ gross profit margins on them. The more add-ons a customer signs up for, which are only a few dollars each, the higher the profit on the sale because these additional trinkets are “pure profit” in every sense of the word.
Don’t become myopic about gross profit margins until you have determined exactly which business model your firm or a potential investment is following. Sometimes, the best way to generate the highest return on investment is to lower the gross profit margin and go for asset turns. Other times, the best way is to raise gross profit margins and sell fewer units. That is where judgment and experience come into the picture; you have to decide that on your own.
As such, when you are analyzing a company, you do want to pay attention to changes in gross profit margin levels. It could signal a shift in strategies. The last thing you want is a surprise.