You know gross margin impacts your profit, but have you considered the impact it has on the value of your company?
When assessing your company’s value, acquirers and investors will often scrutinize your gross profit margin. As you likely already know, gross profit margin is the difference between a company’s revenue and its cost of goods sold (COGS).
While the Cost of Goods Sold (COGS) calculation does not typically include general operating expenses, it should include direct labor expense associated with producing and delivering the product or service. A lot of businesses don’t do a particularly good job in allocating labor properly and this can come back to haunt them when they go to sell. Often times an acquirer will attempt to go back and make these adjustments themselves to gain a better understanding of profitability. If significant adjustments are called for, it will almost always negatively impact their determination of value.
A high gross profit margin is a crucial factor for investors and potential acquirers as it can indicate that a company has established pricing power through marketing differentiation and possesses a competitive advantage and a strong competitive moat is an indicator of a company’s long-term sustainability. In addition to providing indication of pricing power, an improving gross margin trend gives insight into the degree of operating margin that exists in the business. Attractive operating leverage often exists in manufacturing businesses that have significant excess capacity.
Conversely, when a company’s gross margin shrinks, it indicates to investors that the company may be competing on price. This is typically a sign that the business lacks a unique value proposition or marketing differentiation and that competing on price is the only way to attract customers.
24 vs. 6 Times Earnings
To illustrate the impact of gross margin on a company’s value, let’s compare two companies: Apple and Dell. Apple has a strong competitive advantage and a healthy gross margin, whereas Dell’s competitive moat is weaker and its gross margin is lower. In 2022 Apple’s average gross margin was 43%, compared to just 23% for Dell.
Apple has a highly differentiated brand and controls the buying experience through its Apple Stores. Additionally, Apple has invested in a range of high-margin subscription offerings, such as Apple TV and Apple Music. The market is willing to pay more than 24 times Apple’s 2023 earnings forecast, and the company has a market capitalization of over $2 trillion.
By contrast, Dell offers commoditized technology products, which puts them in a weaker competitive position, requiring them to compete on price and resulting in a lower gross margin. The market is only paying around six times Dell’s 2023 earnings estimates, giving it a total market capitalization of around $30 billion.
Just as gross margin impacts the world’s largest publicly traded companies, it also impacts smaller businesses. Ron Holt started Two Maids & a Mop, a residential cleaning company, in 2003. Holt ran a lean business and enjoyed healthy gross margins and a net profit margin of around 30%. Holt invested his earnings in differentiating his business from mom-and-pop cleaning services. He built a network of 12 locations across the southern U.S. and had plans to expand across the country.
Holt was curious about franchising as a business model and attended a Las Vegas conference where he had a chance encounter with Subway founder Fred DeLuca. Subway had more than 40,000 locations around the world at the time, so Holt asked DeLuca for his expansion advice.
Armed with DeLuca’s advice, Holt grew Two Maids & a Mop from 12 to 91 locations and $40 million in revenue without seriously compromising his gross margin. In 2021 Holt sold his business to JM Family Enterprises for over ten times EBITDA.
Apart from raising prices or reducing input costs, an often overlooked approach to improving gross margin is to invest in carving out a point of differentiation for your business in the minds of your customers. When your customers see your business as unique, you are less likely to have to compete solely on price. Charge a premium for a differentiated product or service, and you’ll beef up your gross profit margin—and the value of your company.