Net margin on the income statement is the earnings found at the bottom divided by gross sales ... the larger the better and a business that has been able to deliver on a healthy net margin over the years that beats both the industry average and is strong across is industries, is a business that Warren Buffett would love.
Before You Can Have Net Margins, You Must Have Gross
Let us turn to good old Joe and his trusty hamburger stand income statement to help illustrate the difference between gross and net margin.
We can see that after cost of goods sold (the direct labor and materials cost that goes into the product or service) Joe's $80,000 of revenue is reduced to $56,000. This is his g
ross income and if we take this number and divide it by sales we get the gross margin. In this case, Joe's gross margin is 70% ($56,000/$80,000) meaning his direct food costs and labor is taking 30% of revenues. In whipping out the old RMA industry common size statement from chapter five, we see that restaurants industry-wise have COGs of 44% with gross margins of 56%. Not too shabby Joe! You are beating the industry by 14% in gross margin ... this truly is something to bat an eyelash at.
So What? What Say You Warren? What Say You?
Well that is fine and dandy that Joe is a superior business manager but keep in mind, Mr. Buffett is looking across the entire business spectrum. Thus, although Joe's Hamburger stand looks great when compared to other restaurants (again, 70% versus 56% is not too shabby), Warren is looking at businesses that generate outstanding gross margin period.
A business that consistently generates a gross margin of 80% whether it is a restaurant or not, is superior to Joe's. Again, cross-industry reports that provide gross margin data similar to our ROE reports will be indispensable at this point.
Well, Gross Margin is Really Not That Gross, Unless You Run a Road-Kill Collection Business, But Again ... So What?
Let us turn back to good old Joe and his greasy income statement in order to delve into the yin to the yang of gross margin ... net margin.
Again, It is All About the Earnings ... In This Case, the Net Margin
The reason that gross margin is so doggone important is that it leads to net margin and if you start off in the income statement with titanic COGs leading to low gross margin, then it is an impossibility to have a strong net margin which is just earnings divided by sales and remember all of the emphasis on earnings in the earlier chapters? If earnings are anemic we do not have the ability to retain the earnings and grow the business ... plus, our ROE should be inherently low since heck ... we are not generating much. We have low return, the three of which, strong earnings, strong return on equity and the ability to retain earnings are the Warren Buffett trifecta. Thus, you can see, gross margin is the first sieve in order to guarantee net margin and the whole process of checking gross and net margin is really just a second check on earnings in order to build a small business that Warren Buffett Would love.
Again, Back to that Net Margin
So we see in the case of Joe's Grease Shack that $4,350 squeaks its way to the bottom line, you can call this earnings or net income folks, your choice. This figure divided by gross sales gives us net margin ... and now we can compare. Just as in the case of Joe's gross margin, everything is relative. In Joe's case, he is generating 5.4% net margin for the year. ($4,350 / $80,000). According to the common size, industry report, restaurants are reporting a 2% net margin. Yikes! This is very slim. Based on this data alone I would be very hard pressed to start a restaurant. I would need to look at a longer track record first to make sure earnings can be generated.
So, compared to other restaurants, Joe is doing well at a 5.4% net margin. This means that his operational expenses are not ravenously eating away his gross margin. Now in the long run, is he watering down the soup and this will eventually catch up to him? Time will tell ... this is why it is so important to examine the business on a ten year basis and examine for long-term perspective.
But ...
So Joe is doing great compared to other Indians in his tribe, but how does this compare across all businesses. Remember, we are looking for margin/earnings here ... if Joe's is doubling his industry's net margin, what difference does it make if the industry is chugging along at 1%?
Quite, honestly, it looks like we all need to get into the beverage manufacturing business since the net margin for this industry comes in at a whooping 17.69%. Coke anyone?
Two Important Things
Again, keep in mind, Warren Buffett doesn't care if you are beating the industry if the industry is sucking wind margin-wise. Again, what is the point in beating the industry margin if the industry margin is 1% (can I hear a "Car Dealer" anyone?) In order build a small business that Warren Buffett would love, we want to make sure we have both healthy net and gross margins across the spectrum.
The other important point, as with earnings and ROE is to check for a long-term track record. I don't care, Warren Buffett doesn't care that the business has had a 20% net margin this year if for the past 9 years it delivered an average 3% net margin. Who cares ... more than likely ... the future will result in a return to paltry margins.
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