Learn to invest with Buffett

Chapter 31

Chapter 5 Section 3 Gross profit/gross profit margin: a key indicator for Buffett to seek long-term profitability
According to last year's financial report, Levitz, the largest furniture retailer in the country, boasted that its product prices are much cheaper than all traditional local furniture stores. The cost is only $44.4.The Nebraska Furniture Store's gross profit is half that.

--Warren Buffett
Buffett believes that when examining whether a company has a sustainable competitive advantage, gross profit and gross profit margin are two key indicators.

Gross profit is gross revenue minus the cost of raw materials consumed by the product and other costs required to manufacture the product.It excludes selling and general administrative expenses, depreciation expense and interest expense, among others.For example, the selling price of a product is 50 yuan, and the sum of the cost of raw materials and the cost of manufacturing the product is 30 yuan, then the gross profit of the product is 20 yuan.Gross profit margin refers to the percentage of gross profit and operating income, expressed as: gross profit rate = gross profit / operating income × 100%.

Buffett believes that gross profit margin can reflect a company's sustainable competitive advantage to a certain extent.If an enterprise has a sustainable competitive advantage, its gross profit will be at a relatively high level.If an enterprise lacks a sustainable competitive advantage, its gross profit rate will be at a low level.

If an enterprise has a sustainable competitive advantage, it can freely price its products or services so that the selling price is much higher than the cost of the product or service itself, and can obtain a higher gross profit rate.For example, Coca-Cola's gross profit margin is about 60%, Wrigley's gross profit margin is 51%, bond rating company's gross profit margin is 73%, and Burlington Northern Santa Fe Railroad's gross profit margin is 61%.

If the enterprise lacks the advantages of sustainable competition, the enterprise can only set prices according to the cost of products or services and earn meager profits.If peers adopt a price reduction strategy, the company must also lower prices accordingly, so as to maintain market share, but the gross profit margin will be even lower.Many companies that lack a sustainable competitive advantage have low gross profit margins.For example, the gross profit margin of General Motors Manufacturing Company is 21%, that of American Airlines is 14%, that of U.S. Steel is 17%, and that of Goodyear Tire Company is about 20%.

Buffett believes that if a company's gross profit rate is above 40%, then most of the company has some kind of sustainable competitive advantage.If a company's gross profit margin is below 40%, then the company is mostly in a highly competitive industry.If the average gross profit margin of a certain industry is lower than 20%, then there must be excessive competition in this industry.For example, the aviation industry, the automobile industry, and the tire industry are all industries with excessive competition.

Of course, a high gross profit margin of an enterprise does not necessarily mean a high net profit of the enterprise.Many companies with high gross profit margins invest a large amount of gross profit in research and development, sales and general management, resulting in a significant reduction in net profit.In addition, the high interest expenses of some enterprises also devoured part of the gross profit.

Investment motto:

The gross profit of the enterprise is the foundation of the operating income of the enterprise.Only companies with high gross profit margins are likely to have high net profits.Investors can refer to the gross profit margin of a company when observing whether the company has a sustainable competitive advantage.

(End of this chapter)