Gross Profitability

[heifien91]

Recently, was reading an equity research write-up that prompted me to research further into a financial measure called ‘Gross Profitability’, measured by Gross Profits divided by Total Assets (GP/TA). In the research paper written by Noxy-Marx in 2010, he discusses that GP/TA ratio is actually a better predictor of future returns than more widely used earnings- and cashflow- based valuation metrics. Was wondering if any other valuebuddies uses such a metric or has thoughts on it?

I compiled the highest profitability quintile companies, which can be found here.

[mohican]

This is the first time I have come across this particular measure, although it does look like a modified version of ROA (using GP instead of net earnings). Intuitively, I can see the logic in the measure as companies which consistently provide a high ROA (or GP/TA ratio) is indicative of some form of sustainable competitive advantage. So over the long term, picking and investing in companies with strong economic moats should provide a superior return.

In practice, I wonder how this can work as:
1) there is no link to valuation (you could be buying overvalued companies although over a long investment horizon, the entry price is less important)
2) my sense is that you would need to apply this method to fairly large companies where financial margins have stabilised (for a market like Singapore I don't think there is sufficient critical mass; had a quick glance at the spreadsheet you attached and there are a number of companies with high GP/TA that I personally wouldn't touch)

I did not read the research paper by Noxy-Marx so apologies if some of my comments are out of context.

[heifien91]

In some ways yes, it is like ROA. However, I find it cleaner as ROA using earnings, whereas GP/TA uses gross profits. If we think about it, as we go further down the income statement, the more ‘polluted’ profitability measures become. Say if a firm generates higher revenue and has a lower cost of production compared to their competitors, they are unambiguously more profitable. Despite that, the firm can still have lower earnings. Reason being, the firm could be increasing their revenues through aggressive advertising, or commissions to their sales force. Such actions would ultimately reduce their bottom line income compared to their less profitable competitors. Additionally, the firm could be improving their production chain through research and development, investing in capital structures to maintain their competitive advantage, resulting in lower earnings again. Furthermore, such capital expenditures would too lower the firm’s free cash flows.

This is the first time I have come across this particular measure, although it does look like a modified version of ROA (using GP instead of net earnings). Intuitively, I can see the logic in the measure as companies which consistently provide a high ROA (or GP/TA ratio) is indicative of some form of sustainable competitive advantage. So over the long term, picking and investing in companies with strong economic moats should provide a superior return.

In practice, I wonder how this can work as:
1) there is no link to valuation (you could be buying overvalued companies although over a long investment horizon, the entry price is less important)
2) my sense is that you would need to apply this method to fairly large companies where financial margins have stabilised (for a market like Singapore I don't think there is sufficient critical mass; had a quick glance at the spreadsheet you attached and there are a number of companies with high GP/TA that I personally wouldn't touch)

I did not read the research paper by Noxy-Marx so apologies if some of my comments are out of context.

[specuvestor]

Actually if we think about it, all these ratios are trying to do is to have a simplistic way of estimating cash flow return on asset

GM is actually quite different from OM. GM is more external, it refers to the your bargaining power with suppliers on BOM, on your capex and asset requirement (and in most cases rental) and hence depreciating cost, are u able to charge a higher price for your products because of quality, luxury, premium usability, etc. Essentially think Porter's 5 forces

OM OTOH is more "discretionary" from SG&A and staff cost. Hence operating leverage is whether u can drive higher volume and utilisation with the similar base of OPEX. GM usually doesn't change so easily due to the external dynamics, except maybe for bulk discount or during ramp up stages, which we see a lot from tech companies.

Hence we have to consider the differences when we compare across competitors what it means. The corollary is of course it also means little comparing across industry.

As usual ratios are good tools for first cut and industry comparisons, but can never replace understanding the business and its environment with more depth.

[heifien91]

Yup, I agree end of the day we still have to understand the business to understand what is causing the margins to change and all. However, I just use such methods as a form of a screener to be able to zoom into companies that are more worthwhile to look deeper into.

Actually if we think about it, all these ratios are trying to do is to have a simplistic way of estimating cash flow return on asset

GM is actually quite different from OM. GM is more external, it refers to the your bargaining power with suppliers on BOM, on your capex and asset requirement (and in most cases rental) and hence depreciating cost, are u able to charge a higher price for your products because of quality, luxury, premium usability, etc. Essentially think Porter's 5 forces

OM OTOH is more "discretionary" from SG&A and staff cost. Hence operating leverage is whether u can drive higher volume and utilisation with the similar base of OPEX. GM usually doesn't change so easily due to the external dynamics, except maybe for bulk discount or during ramp up stages, which we see a lot from tech companies.

Hence we have to consider the differences when we compare across competitors what it means. The corollary is of course it also means little comparing across industry.

As usual ratios are good tools for first cut and industry comparisons, but can never replace understanding the business and its environment with more depth.

[specuvestor]

Ya first cut Just that I noticed u grouped all the different sectors in one spreadsheet

BTW noticed my typo there: GM usually doesn't change so easily due to INTERNAL dynamics