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Investors pay for high profit margins
Gross Profit (“GP”) Margins – GP margins
determine the core profitability of the company’s products. It is calculated
by dividing gross profit by sales and is expressed as a percentage.
Gross profit is a product’s selling price less the product’s direct cost
of sales. It excludes selling, general and administration expenses. Gross
profit margins are very informative when comparing similar companies. One
can evaluate a company’s pricing and productivity efficiencies by analyzing
gross profit margins. The P&L effects of outsourcing production are
reflected here. I find it useful to think in terms of one unit. What is the
product’s selling price? How much does the product cost? The difference
represents the company’s profits prior to operating expenses, interest, and
taxes. It is also useful for investors to review prior years’ trends, to
compare with future earnings projections.
Operating Profit
Margin
Operating profit margins
depict how profitable the company’s normal operations are. They are
calculated by dividing operating profit by sales, and are expressed as a
percentage.
Operating profit as an
absolute number is also referred to as EBIT, earnings before interest and
taxes. EBIT is widely used by bankers to determine the company’s leverage
capacity and interest coverage.
When reviewing earnings
estimates, understand the operating profit margins, that are being used in
the calculations. Theoretically, margins will increase if a company
increases its sales while keeping some of the infrastructure cost fixed.
Additionally, operating profit margins can improve by increasing selling
prices or by decreasing costs.
Investors, however,
should be especially critical of long-term, back-ended projections, that
show sales growth combined with big operating profit margin improvements in
the future. With the average job lasting only a few years, long-term
projections should be viewed skeptically.
The higher
the margins, the greater the earnings available to the shareholders, and
therefore, the higher the value of the business.
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