Gross Profit Margin: Identifying Businesses with Durable Long-Term Competitive Advantage II

In this part II of the weekly series, we focus on Gross Profit Margins as an indicator of a business with a durable long-term competitive advantage that provides investors significant long-term returns.

As noted in Part I, these businesses have monopoly-like underlying economics that makes them charge more or produce more of their products or services.  Given their durable competitive advantage, the underlying value of the business increases each year.

A look at Microsoft, the world’s most valuable company with durable long-term competitive advantage later on, will show how such businesses continue to dominate market share, expand, and provide significant returns to investors.

A rule of thumb in identifying companies with durable long-term competitive advantage is that the company must have consistently over at least a period of 10 years, recorded gross profit margins of 40% and above.

If a company or business, consistently over a period of 10 years, records gross profit margins of 20% or less, that company does not have a durable long-term competitive advantage.

For companies, that consistently record gross profit margins between 20% and 40%, such companies do not have durable long-term competitive advantage but are healthy companies that investors can look at investing in.

Very few businesses are able to consistently record gross profit margins of 40% and above, that notwithstanding, there are some businesses that have recorded gross profit margins significantly above the 40% threshold.

For example, Asian Paints enjoys a 50%+ gross margin due to its dominant market share, pricing power, and extensive distribution network.

Similarly, Pidilite Industries, known for its Fevicol brand, operates in a consolidated adhesives market with limited competition. This allows Pidilite to enjoy gross margins upwards of 60% as it is able to price products premium and has bargaining power over raw material suppliers.

Gross profit margins vary by industry, for instance, Airlines often have gross margins of 10-20% due to high fixed costs, including labor, fuel, maintenance, and aircraft leases. After covering operating costs, they deliver bottom-line profit margins of only 3-5%.

Also, companies in capital-intensive industries like manufacturing and transportation often have lower margins, around 20-30%, while software and consulting services are able to achieve 70% or higher.

The average gross profit margins for major industries such as agriculture and commodities are 15-30%; aviation 7-15%; automobiles 15-25%, banks and financial services 70-90%; electricals and electronics 25-50%; Fast Moving Consumer Good (FMCG) ie milk, fruit, beverage, etc 20-40%; gas and petroleum 8-15%; and information technology 60-85%.

Recorded Gross Profit Margins of Microsoft since 2011 – 2023

Average Gross Profit Margin of Microsoft

 

Above, are two images detailing the history of gross profit margins recorded by Microsoft.

The first image displays the recorded gross profit margins of Microsoft from December 2011 to December 2023 – over the last 12 years.

The second image shows the average gross profit margin of Microsoft over a period of time ie 3 years; 5 years; 10 years; 15 years and 20 years.

With the first image, it can be noticed that over the last 12 years, the least and highest gross profit margins recorded by Microsoft were 58.51% in December 2015 (which is way above the 40% mark) and 77.3% in March 2012 respectively.

In the second image, Microsoft records a 10-year gross profit margin of 67% which is significantly above the 40% mark for a company with a durable long-term competitive advantage.

For a 15-year and 20-year period, Microsoft performs even better recording gross profit margins of 70.5% and 73% respectively.

Now, a company that reports let’s say gross profit margin of 45% for instance, is communicating to investors that for every 1 Ghana Cedi (or $1) received as revenue, 45 pesewas (or 45 cents) comes to the company as gross profit. Similarly, a company that reports a gross profit margin of say 23%, is communicating to investors that for every 1 Ghana Cedi (or $1) received in revenue, 23 pesewas (or 23 cents) comes to the company as gross profit.

Hence, over a 20-year period for instance, for every dollar received by Microsoft as revenue, 73 cents of the dollar goes to the company as gross profit.

Companies with wider gross profit margins have more flexibility to cover fixed costs, invest in new products and capacity, and reward shareholders/investors heavily.

For instance, Microsoft shareholders have for the last 10 years enjoyed increased dividend payments notwithstanding the reduced dividend payout ratio by the company – Microsoft has reduced its dividend payout ratio from 82% in 2015 to 26% at end-2023.

Despite the significant reduction in dividend payout, annual dividend payments per share to shareholders by Microsoft have grown steadily from $0.92 (GHS 11.54) in 2013 to $2.72 (GHS 34.11) in 2023.

For 2024, shareholders are expected to receive $3 per share (GHS 37.62) in annual dividends.

Gross Profit Margin measures how much profit a company generates after accounting for the direct costs of goods sold. This is done before subtracting operating expenses like research and development (R&D), salaries, rent, etc to arrive at a net profit margin.

It is usually calculated as a percentage of revenue.

Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue X 100%

Expanding margins signal growing profits through improved pricing or cost controls while declining margins raise questions about pressures eroding performance.

Declining gross profit margins over time sometimes signal issues like increased competition, supply chain problems, or mismanagement.

 

The writer has certifications in Wealth & Investment Management as well as Investment Advice and Portfolio/Fund Management from the Chartered Institute for Securities & Investment (CISI, UK) and the Ghana Investment and Securities Institute (GISI) respectively. 

Comments and views can be sent to the writer via the email address [email protected]