Focus on the metric that could transform your company’s value
Written by Cantava
Most business owners know gross margin impacts profit, but research suggests a smaller proportion of owners consider the impact it has on the value of their company.
When assessing a company’s value, acquirers and investors often scrutinise that company’s gross profit margin, which is defined simply as the difference between a company’s revenue and its cost of goods sold. In other words, it’s the profit a company makes from each unit of product or service sold after accounting for the cost of producing or delivering that unit, but does not include other fixed expenses. For example, if a company sells a product for £100 and it costs £70 to produce and deliver it, the gross profit margin would be £30, or 30%.
A high gross profit margin is a crucial factor for investors and potential acquirers, as it indicates a company has established pricing power through marketing differentiation and thereby possesses a competitive advantage. A strong, competitive moat is an indicator of a company’s long-term sustainability, making it more appealing to potential investors.
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 its only way to attract customers. A shallow moat leaves the company vulnerable to competitive threats and makes it less appealing to potential acquirers.
24 versus 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 capitalisation of more than $2 trillion.
By contrast, Dell offers commoditised 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 capitalisation of around $30 billion.
Smaller business use case
Just as gross margin impacts the world’s largest publicly traded companies, it also impacts smaller businesses. Consider this example from the U.S. that appeared recently in one of our newsletters.
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.
Following comments from a couple of employees, 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.
DeLuca cautioned Holt about actioning every idea from his employees as his company got bigger. He told Holt, “Most of the time, employees bring you ideas to make their life easier, not necessarily to make you more money. Every time you make your employees’ lives easier, it comes at a cost.”
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 more than 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.