Investors can use the gross profit margin as a tool to help evaluate stocks. The gross profit margin is calculated by dividing sales by the cost of goods sold. Both figures are available on the income statement released by publicly traded companies. A company with consistently high gross profit margins points to a sound business model. A low gross profit margin is a red flag that the company is struggling. Gross profit margins are a first step in evaluating a company.
Gross Profit Margin Trend Analysis
An investor should use trend analysis to evaluate a company's performance over time. A company that has gross profit margins that are increasing over time points to a successful operation. A company with up and down profit margins or declining profit margins over time is a cause for concern. An investor should dig deeper to determine what is driving the changes in gross profit margin. Margins can deteriorate for many reasons, perhaps raw materials are becoming more expensive or new competition has led to lower prices.
Peer Gross Profit Margin Comparisons
An investor should also look at a company's peer group gross margin performance to see how it stacks up to the competition. Finding a peer group that exactly matches a company is difficult, if not impossible, but many financial websites will suggest competitors. It is important to spend time selecting a logical peer group to make a fair comparison. Once a good peer group is selected compare the gross profit margins to determine if the company is near the top, middle or bottom of its peer group.
Comparing Gross Profit Margins to Industry Averages.
Sometimes illuminating information can be found by comparing a company's gross margin with industry averages. This is useful to show how a company performed compared to an average. If the company is consistently performing above average over several years it is a good indication that management is doing a good job. In addition, it is useful to see how the company's gross profit margin compares to the average gross profit margin of other industries.
Tips and Tricks
Sometimes companies use earnings management to smooth out income over time and this can distort gross profit margin performance. A company might move sales from one financial reporting period to another. This can distort the gross profit margin. Sometimes companies are under tremendous pressure to meet earnings expectations. An investor should be wary of management motivations because by recognising sales earlier than normal, meeting performance expectations in the next reporting period will be more difficult.