Morris asks: When I'm looking at a stock or company to invest in, what do you think is the most important thing to look for on the income statement?

Hi Morris,

Like most investment analysis questions, you will probably receive a wide variety of answers to what to look for on an income statement. Some analysts like to look at net income, while others focus on Operating Income or EBITDA (a non-GAAP metric).

Gross Profits and Gross Margins are Essential Financial Metrics
My personal opinion is that the most important metric to focus on is a company’s Gross Profit and resulting Gross Margin. Gross profit is simply Revenues – Costs of Goods Sold (COGS). Gross Margin can be calculated by dividing Gross Profit/Sales. Incidentally, I am of course excluding biotech companies and other early stage ventures from my answer, since there really isn’t anything on the income statement to analyze for these types of companies.

Gross profit and gross margin are important for several reasons.

Gross Profit is Not Easily Manipulated
First, gross profit is really the only measure of profit that is not influenced by all sorts of non-recurring, non-cash and other irrelevant operating costs. Since the gross profit is a number that is less easily manipulated, it is a good metric to use when assessing a company’s core profitability.

Gross Margin Signals Business Value
Second, since the gross margin is an indication of the type of mark up a company charges over and above the costs to produce a specific product/service, the gross margin provides a good indication of strength of the company’s value proposition to customers and the extent of the company’s pricing power. In general, it is best to invest in companies that have a strong value proposition and some degree of pricing power, a situation that is implied by a high gross margin.

It’s Easier to Spot Value When Focusing on Gross Margins
Third, since operating expenses are easier for management to control, gross profits provide a better clue as to the future profitability of a company. For example, at times you will find a company with a very high gross margin losing money, and the stock price may have declined substantially as a result. However, new management may take over the company and quickly reduce variable operating costs, returning the company to profitability and leading to a substantial increase in the stock price. By focusing on gross margins, you can spot the potential value in a business, even if the company is losing money or overall profitability is depressed.

Gross Margin Analysis is an Art
With that said gross margin analysis is still tricky and is a bit of an art. For one thing, what defines a high gross margin? And is a low margin always a negative?

High vs. Low: It’s Relative
In terms of high or low margin figures, the evaluation like most quantitative measurements is entirely relative and it requires some experience. Many businesses look awful when compared to a company like Microsoft (MSFT) which reported a 78% overall gross margin in the last fiscal year. At the same time, a company like TravelZoo (TZOO) reported an over 90% gross margin, implying that MSFT’s gross margin was actually low! Of course, just looking at TZOO’s gross margin as compared to MSFT is too simplistic and misleading. It’s really only after looking at hundreds of companies that one can begin to appreciate which companies have high or low margins. In general, to keep things simple, I do tend to avoid companies with gross margins beneath 40%, but even then the analysis is never cut and dry.

The Most Crucial Analysis for Investing is Determining the Direction of the Gross Margin
The trick is really to focus on the direction and potential change in the gross margin, rather than the absolute level of the gross margin. The gross margin vector, to use a mathematical term, provides a great indicator of a stocks investment potential. So for example, at times a company may have a very low gross margin relative to most other businesses, but changes in product mixes or industry conditions, may indicate that a substantial improvement in gross margins is probable in the near future. In this instance, even a low gross margin company is worth of investment consideration. The same can be said for a high gross margin. At times, an analysis will reveal that the high gross margin is unsustainable.

A good example of analyzing the potential direction of gross margins is Power One (PWER). When I looked at PWER back in 2008, the company’s gross margin looked downright pitiful at a mere 20%. But, of course the absolute number was misleading since PWER was embarking on a major corporate overhaul with a focus on higher margin solar inverters. As PWER’s solar inverter sales increased over the next two years, the company’s gross margin soared to nearly 40%, the company’s profits improved dramatically, and the stock price zoomed higher by nearly 500%. It was the understanding of the potential for a major change in the direction of the gross margin at PWER, rather than an analysis of the company’s absolute level of gross margin at that time, which proved critical in determining the investment opportunity presented by PWER back in 2008.

Take Marketing Intensity into Account when Analyzing High Gross Margin Businesses
One final note about gross margins is that even when a company reports high gross margins, the situation is not necessarily all that rosy. In some instances, the company is potentially very “marketing” intensive, and therefore the high gross profit is misleading, since the gross profits will be quickly diminished by essential marketing expenses. A good example of this is a company like NutriySystem (NTRI). While NTRI reports satisfactory gross margins above 50%, the reality is that, as a diet company, the company’s customer base churns rapidly, and as such the business requires substantial marketing expenses to replace lost customers. In this and other instances, comparing the gross margin to a company’s “marketing intensity”, as opposed to looking at gross margin in isolation, is crucial to understanding the investment opportunity.

In sum, start by calculating a company’s absolute gross margin and then compare it to other companies in your research universe to provide some frame of reference to help determine if the margins are high or low. In general, you’ll want to stay clear of low margin companies, but it’s extremely important to look at each investment individually, to see if there is a potential for a change in the direction of the gross margin. The way to make money investing is to spot these potential changes before others. Finally, analyze the gross margin in relation to other business variables.