Gross margins increased... Gross margins fell... Gross margins were light... At one point or another -- especially during earnings season -- you have probably read or heard about a company's gross margins. But why?

Understanding a company's gross margins is a big part of fundamental stock analysis, as it's directly related to just how well a company is able to make a profit, and can have a big influence on its stock price.

What Are Gross Margins?

Simply put, gross margins are the revenues a company has left over after the cost of production. A gross margin comes from a company's income statement -- it's the difference between revenues and cost of goods sold (COGS, also referred to as cost of revenue), which can be either a dollar number (gross profit) or a percentage. Gross margins are essentially a measure of profitability.

Let's say that you own a company that produces umbrellas. Each umbrella costs $5 to make and is sold for $10. So the gross profit on an umbrella is $5. But what is the gross margin on that umbrella? 50%. How? Revenue ($10) less cost of revenue ($5) divided by revenue ($10) multiplied by 100. And while this number is vastly useful for investors, it's important to remember that there are some items that come in between the gross profit and net income.

Things such as "selling, general and administrative" expenses can have a huge impact on the bottom line of a company with an otherwise awesome gross margin. So why is the gross margin such an oft-touted fundamental metric?

How Gross Margins Affect a Company

Like any other fundamental metric, investors should be interested in gross margins to help get an idea about a company's overall financial health and current performance. Gross margins play an essential role in helping predict a company's future performance because they have such a major influence on a company's bottom line (see profit).

Simply put, when it comes to gross margins, bigger is better -- the market likes companies that make comparatively more money on each unit (of whatever their product or service is) they sell. And gross margins are invariably tied to a company's break-even point: In order to compensate for fixed elements of COGS, products with lower margins need to be sold at a higher volume than those with higher margins.

So if you're investing in a company that targets a smaller market, you should see higher margins on their products. This is a market concept that can be seen in the book industry: While it likely costs approximately the same amount of money to produce a mass-market hardcover book as it does a college textbook, the textbook has a smaller base of potential customers, so it's marked up a whole lot more.

How Gross Margins Affect You

If gross margins can affect a company's bottom line, they can certainly affect your bottom line (see return). On the stock market side, movement in a company's gross margins can translate to movement in its share price. How? If a company is losing profitability ( falling gross margins), it will look less attractive to investors, and the share price will suffer. Conversely, increasing margins can lead to an increase in share price (see earnings per share).

Because of the influence gross margins have on a company's bottom line, they also play a part in a company's propensity to declare dividends. Naturally, higher gross margins often play into a greater dividend yield for stockholders.

How to Find Gross Margins

You can determine company and industry gross margins by exploring a plethora of financial Web sites. For example, the Reuters site has an easy to read "Ratios" section on its stock quotes pages.

When it comes to looking at the gross margins for actual companies, there are several things you'll want to consider: industry comparisons, margin movement and gross profit.

Industry Comparisons

Benchmarking comparable companies is just as important when you look at gross margins as it is with any other measure of fundamental performance. And to really get a grasp on how a company's gross margins stack up against its competitors' numbers, you need to take a look at the industry average -- it's essential.

Let's say you're evaluating the performance of Whole Foods ( WFMI). Whole Foods' last annual gross margin of almost 35% may not look all that impressive against the S&P 500's (what many consider to be a pretty good standard for comparison) gross margin average in the mid-40% range, but when you take into account that the grocery industry's average gross margin rings in at approximately 25%, then Whole Foods' performance level becomes a little clearer.

And when you compare its gross margin against a couple of competitors like Safeway ( SWY) and Kroger ( KR), the performance and profitability picture comes into focus even more. Here's a look at how these three grocers stack up:

Based on Annual Income Statement Data for Fiscal Year 2006
Company Gross Profit
(Revenue - Cost of Revenue)
Gross Margin
(Gross Profit / Revenue x 100)
Whole Foods $1,960*
($5,607 - $3,647)
34.95%
($1,960 / $5,607 x 100)
Safeway $11, 581
($40,185 - $28,604)
28.81%
($11, 581 / $40,185 x 100)
Kroger $15,996
($66,111 - $50,115)
24.19%
($15,996 / $66,111 x 100)
Source: Google Finance
*Numbers in millions of U.S. dollars.

Margin Movement

Change in gross margin is also really important. There are countless conditions that can affect a company's margins, and poor margins one year shouldn't necessarily be the deathblow for an investor.

For example, Apple ( AAPL) recently saw their margins jump 6.6% (from 30.3% in the first quarter of 2007 to 36.9% in the second quarter of 2007) -- a feat that may have made up some ground against inflated analyst iPhone expectations.

Remember, though, that downward movement can be an ominous sign of things to come -- losing suppliers, tough changes in materials prices and labor negotiations can all drive gross margins down in a lasting way (see "Alcatel-Lucent Swings to Loss").

Gross Profit

While percentage measures like gross margin are great to use comparatively, gross profit provides investors with an absolute measure that's useful in measuring a company's scale. High gross margins are great, but if the company's sales are not enough to make a profit in the first place, their per-unit gross margins become a bit of a moot point.

In the same vein, watch out for companies whose income statements show stifling general, selling, and administrative expenses (these are reported as line items on the income statement) -- they can really muddle up that gap between gross profit and the bottom line (see "Getting Started: The Income Statement").

Margin Watch

Gross margins are an integral part of analyzing a company's income statement. They give investors guidance as to per-unit profitability, and can be immeasurably useful in predicting future performance. Watching a company's gross margins is a great way to make sure that you're not marginalizing the gains in your portfolio.

Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.

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