Gross profit margin demonstrates competitive advantage: it is the purest expression of customer valuation of a product, clearly implying the premium buyers assign to a seller for having fashioned raw materials into a finished item and branding it.
Although gross margin is a partial function of a company’s industry and high gross margins can reflect low asset intensity, sustained high gross profit margins relative to industry peers tends to indicate durable competitive advantage. Zeroing in on gross margins, as opposed to bottom line net income, also helps distinguish competitive advantage from managerial ability: bloated but short-term cost structures can reduce net income and disguise real long-term competitive advantages. High gross margins also confer other advantages: they can expand the scope for operating leverage, provide a buffer against rising raw material prices and provide the flexibility to drive growth through R&D or advertising and promotion.
The more incremental top-line revenue that ends up as bottom-line profit, the better. Suppose two rivals each grow revenue by a dollar. If it costs one of them ten cents to do so and the other 80 cents, the growth is clearly more valuable for the former. Businesses with high operating margins are typically stronger than those with lower ones.
Sustained margin expansion also signals strength. Big swings in operating margins can indicate that major cost components are outside of management’s control, suggesting that caution be applied. A company that consistently achieves both high gross and high operating margins indicates a strong competitive advantage sustainable at tolerable cost.