When Adobe (ADBE:NASDAQ) reported second quarter figures in June 2022 it unveiled earnings that beat forecasts, reporting $3.35 versus consensus estimates of $3.31. So far, so what? The market shrugged the results off – the share price dipped 1.2% to $360. Yet this was the latest in a long run of quarterly forecast beats that, barring a single period in 2018, stretch back to 2013.

Since then, Adobe’s market valuation has surged to $190 billion as its stock rallied hard, up more than 760%, and that’s after the extreme challenges presented this year.

The secret to this enormous wealth creation (or one of them) is the firm’s high gross margins. These were 87.7% in Q2 2022, and in the five full years (to November) between 2017 and 2021, gross margins have averaged 86.6%.

A business that has high gross margins has much more of a buffer to handle adversity and rising costs. It usually means that the products or services sold are not only in demand but are often critical to clients. That gives them important pricing power, so as inflation has soared this year, putting up the price of doing business, companies like Adobe have been able to pass on these higher costs to customers through price increases. Adobe itself did just that in April.

It is why high gross margin businesses tend to attract higher stock market valuations than average.

GROSS MARGINS IN A NUTSHELL

Gross margin, or gross profit margin, is a way of measuring the amount of profit a company has left after subtracting the direct costs associated with selling its goods and services. Things like raw materials, staff salaries and utility bills.

Gross margin is calculated by dividing gross profit by gross revenue and multiplying the figure by 100 to get a percentage. The percentage figure represents the portion of revenue that can be kept by the company as profit.

The higher the margin percentage, the more effective the company is in generating revenue for each dollar or pound of cost.

Gross revenue is the total amount of money the company makes from selling its goods and services.

Gross profit is the amount of profit the business makes after all costs are deducted, such as manufacturing costs.

Gross margin is profit divided by revenue.

Gross margin tells investors a few things. First, it tells them how much of a company’s revenue (the total amount of money received) is kept as a profit. So, if the gross margin is 80%, it means the company has made 80p of profit from every £1 in revenue. This helps investors establish if a company is using its money efficiently.

Secondly, gross margins can give an insight into what shareholders might receive, as dividends are paid from profits. Lastly, it helps investors to compare competitor companies to each other.

Gross margin also offers useful insights for companies themselves. It can be used to measure production costs against revenue. If the gross margin is very low, the business may want to cut production and manufacturing costs to increase profits.

Sticking with Adobe, in much the same way that Netflix (NFLX:NASDAQ) sells streaming subscriptions to consumers, Adobe does the same to creative business customers. Once it has sunk the cost of developing a software product, its cost of new subscription sales is low, or marginal, as analysts call it.

It can be similar with online platform businesses, where the cost of new business can be marginal. Autotrader (AUTO) and Trainline (TRN) both averaged gross margins of more than 80% over the past 12 months, although Moneysupermarket (MONY), which runs a similar online platform model, has gross margins        of 69.1%, something investors might want to dig into before investing.

Investors can use gross margins to compare similar businesses, Adobe against Autodesk (ADSK:NASDAQ) say, which sells engineering design software solutions.

Small business accounting software supplier Sage (SGE) has trailing 12-month gross margins of 93.1%, according to Sharepad data. Its largest variable to that gross margin is likely to be technical talent recruitment and retention, and product development. Yet with nearly 94% of revenues recurring from products already available, these factors are unlikely to drag significantly on overall profits.

GROSS MARGIN LIMITATIONS

Apple (AAPL:NASDAQ) is also (in part) a software company, but when we look at its gross margins, they compare poorly with Adobe and Autodesk. In the 2017 to 2021 full years (to 30 September), Apple averaged a 38.9% gross margin. The yawning gap between Apple and Adobe/Autodesk is because Apple makes most of its revenue by selling iPhones and other gadgets, hardware in other words, which require billions of dollars of components (microchips, circuit boards, batteries, glass etc) to manufacture.

Comparisons become even less useful across different industries because financial structures, production efficiencies, raw material requirements and the levels of competition are different.

Fashion retailer Next’s (NXT) 42.6% gross margin is far below software company examples above because it has to contend with the impacts of rising manufacturing costs (energy, workforce wages) of suppliers and raw materials price hikes (wool, cotton, silk, leather), on top of its own cost of operating pressures.

That Dr. Martens (DOCS) trades on a 64% gross margin tells investors about the power of its brand, by contrast.

Supermarkets run on far thinner gross margins as they contend with all of the above, plus vicious competition as they battle for customers. The average trailing 12-month gross margins of Sainsbury (SRBY) and Tesco (TSCO) was 7.9% and 7.5% respectively.

There are even industries, property, utilities and financial services, for example, where gross margins are not meaningful.

Ultimately, gross margins are just one element of fundamental analysis that help investors to gain key insights into how reliable future profits are likely to be, and what decisions management might make down the line to improve a company’s prospects.

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