Thursday, May 3, 2012

Investment Analysis: Gross Margin

Today I'm covering the quality of earnings indicator, "Gross Margin."  

The premise behind this marker is that disproportionate changes relative to sales are informative.  According to Lev, Thiagarajan and presumably many analysts, gross margin is a better-than-earnings figure for determining the relationship between a firm's input and output prices.  This price/cost ratio reflects interesting underlying factors such as the intensity of competition and the degree of operating leverage.

This measure takes the difference between the percentage change in sales and the percentage change in gross margin:

 % change in gm - % change in sales

As I mentioned above, it is the disproportionate changes which are informative.  L & T specifically state that a larger decrease in the gross margin relative to a decrease in sales is a negative sign.

Thus, in the above example, the formula would yield a negative number.

We would also get a negative value if the % change in gm increased, but the % change sales increased more.  

We'll get a positive value when there is a larger increase in the gross margin than in sales.  We'll also get a positive value when there is a smaller decline in the gross margin when sales also decrease.

If this isn't clear, let me discuss this for a moment in business terms.  The formula for gross margin is:

(Sales - Cost of Goods Sold) / Sales

The cost of goods sold are the inputs that are going to track very closely with the actual sales made.  For example, if you make nails, you cost of goods sold will be the raw materials, steel, and the direct labour.  If your sales go down, you need less inputs and your cost of goods sold go down. The reverse happens when your sales go up.  So the normal situation is a tight correlation between sales and the cost of goods sold.

When the situation deviates from the norm it can indicate either that efficiencies have been lost or they've been gained.  They're lost if the relationship moves apart.  They're gained if they move tighter together.

We capture this "movement" in the formula above.

I'm going to do the actual investment analysis tomorrow.  There is another nuance that I want to mention with this particular measure that isn't discussed by L & T, but does concern me.  I think that either small deviations should be ignored (and given a rating of zero) by arbitrarily choosing a range (such as between -5% and +5%) OR the analyst should benchmark what is "normal" for the company and then fluctuations outside that range be rated appropriately.  It is something to consider and when we build the actual financial model on this indicator we can make some judgments.

Thank you for reading, and I'll be back tomorrow.

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