How Gross Margin Impacts Business Valuations

What is Gross Margin?

A company’s gross margin represents the percentage of gross profit divided by total revenue. Gross profit is total revenue minus the Cost of Goods Sold (COGS) where COGS is the labor and material costs in producing goods or services. Thus, a business with $1M in sales and $600K of COGS will have a gross profit of $400K and a gross margin of 40% ($400K/$1M). The gross margin of a business is in reality a reflection of its pricing power along with its ability to efficiently produce goods or services. When buying or selling a business, measuring current and historical gross margins – especially compared with other businesses in its industry – is an important metric in gauging the depth of a company’s competitive advantages as displayed by superior pricing power or cost efficiencies. An experienced business broker should highlight the strong gross margins of a business in order to justify a premium purchase price.

Pricing Power

Pricing power is a company’s ability to raise its prices without experiencing a significant drop in demand or lost customers to competitors. Even during times of inflation, a business with strong pricing power is able to pass along its production costs to its customers. This protects the gross margins of the business, and over time will lead to stable and increasing profits. A business with strong pricing power is likely to have brand loyalty, product uniqueness, and high switching costs among its customer base. Pricing power reflects the strength of a company’s intangible assets or goodwill that sets it apart in the marketplace. Moreover, a business with pricing power is likely to face less competition than a business with little or no pricing power. Often, the lack of competition is due to high barriers of entry in structurally advantaged industries such as pawn shops protected by zoning laws which limit new entrants in the local market.

Cost Advantages

The ability to produce a good or service for lower costs than the competition over the long-term will lead to high gross margins. Imagine two factories turning out widgets and each realizing $1M of revenue per year. The first factory has production and labor costs of $800K, resulting in a gross profit of $200K or a 20% gross margin. The second factory has more modernized and efficient equipment with a better trained workforce. As a result, the second factory’s production and labor costs total $600K, resulting in a gross profit of $400K or a 40% gross margin. Cost advantages also arise from economies of scale resulting in lower supply costs. Another factory producing widgets may be a part of a chain that benefits from purchasing its supplies in bulk across a national supply chain.  This may result in massive cost savings that increase its gross margin above other competitors.

Gross Margin Affects Valuation Multiple

A business with a high gross margin due to competitive advantages resulting in strong pricing power or operational efficiencies should receive a higher valuation multiple when it comes time to sell. The competitive advantages may be structural in nature (due to industry dynamics) or only pertaining to a specific business (based on a superior business model). So long as the competitive advantages transfer to the buyer, the business should sell for a premium valuation multiple. Additionally, businesses with strong gross margins tend to have a high Return on Equity (ROE) or profits divided by net assets. This arises due to the efficient use of capital in retaining profits as a percentage of revenue. High ROE businesses receive a higher valuation multiple since less capital is needed to sustain its profits and scale the growth of the business over time. Lastly, businesses with high gross margins are less susceptible to inflation and competitive risks which creates more certainty for buyers and hence raises the valuation multiple.

Example of Valuing Business with Strong Gross Margins

  • Let’s say that Adam owns Adam’s Remodeling Center which designs and installs kitchens and bathrooms for residential customers throughout South Florida.
  • Adam is considering selling his business, and is seeking a business valuation from a professional business broker.
  • The broker notices that Adam’s business has a 50% gross margin after paying for supplies and labor.
  • Overall, Adam has $2M of total sales, $1M of gross profits, and $500K of net profits or adjusted owner benefit.
  • The typical valuation multiple for Adam’s business is 3x owner benefit or $1.5M, but Adam’s business must be closely analyzed to understand why the gross margin is so high.
  • The broker discovers that the business has strong pricing power with its customers due to the unique styles of appliances, countertops, and cabinets it orders from overseas suppliers which no other local competitor can match.
  • The business is also fully staffed by highly trained and motivated employees, and employs an efficient business model that lowers its installation and production costs.
  • Since the business also has a strong history of growth and ample room to profitably scale into adjacent markets given its high ROE, the broker wisely decides that Adam’s business should be priced at a premium valuation multiple of 4.5 x or $2.25M ($500K x 4.5).
  • The premium valuation multiple should be justified to potential buyers based on its unusually strong pricing power and cost advantages.

Valuing a business with a high gross margin must take into account its competitive advantages and high ROE in order for the business owner to receive the maximum purchase price when it comes time to sell. Sometimes, business owners are better off by removing low margin revenue streams from their business model (‘addition by subtraction’) prior to selling in order to increase their gross margin and attractiveness to potential buyers.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.