Saturday, July 16, 2022

How to invest - part 1. Preparation - How - Fifth Part

 Today we will be touching on the Gross Profit margin:

Simply put, Gross Profit: Revenue - Cost of goods sold

Then, Gross Profit Margin : Gross Profit / Revenue

In other words, you take your sales, and minus off whatever cost you directly incurred to make that sale, and you have your gross profit, in dollar amounts.

Then, you divide this gross profit by the sales amount - this tells you how much profit you make per $1 of sales, percentage wise. 

So, if company A makes $100 in revenue, and spends $20 in promotion, hiring temp staff etc, the gross profit is $80 and its gross profit margin is 80% - which is real damn high, but not unusual.

What this % does is, it tells you a couple of things:

1. If you have a company that is high in gross profit margin, it tells you that the profits it makes in relation the costs it needs to spend to make a sale is quite high, and this also tells you the company manages to keep its selling costs low. 

How does a company keep its costs low? Couple of ways: the company manages to source for material cheaply, which may signal the company has a unique hold/access to its raw material(s) or manages to strike a good deal with its supplier and can keep costs low for a certain amount of time

2. Say, you know this industry really well and the prices of its raw materials are quite standardized/commoditized so any company in this industry faces roughly the same costs. So, based on point 1, you think the gross profit margin should be roughly the same for all - but, you noticed there are one or two companies that seem to have higher than average gross profit margin. 

This probably means the company is able to charge a higher price ie bring in more revenue. Now, if you have a company or a few companies that are able to charge higher than its peers in an industry where the cost of goods are about the same, you may think these companies are doing something different.

Perhaps they have a good brand, strong marketing, excellent after sales, awesome customer retention, constant updates and improvements to their existing and new products/services - in warren buffett's terms, the company has a strong moat(s).

Definitely save a company like this in your watchlist for further study !

So, just with gross profit margin, and revenue, you can do abit of preliminary analysis:

1. Check the revenue growth of company A vs the revenue growth of the industry.
If its higher than the industry, it means A is eating up its competitor's share but also pay attention if the revenue growth of the industry starts to decline - it may signal the beginning of the end. Like Kodak and the digital camera market.

2. Compare the gross profit margins between a group of companies in the same industry, and you can kind of get a sense of which companies has good cost management (this does however warrant a deeper dive to get a full understanding of all the other costs a company incurs), good pricing ability, and in turn, good/strong economic moats.

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