When it comes to your company’s bottom line, cash flow is queen (or king, if you prefer).

A steady cash stream allows you to pay yourself, your employees, and your vendors. Cash on hand enables you to take advantage of opportunities and provides a buffer against economic downcycles. It makes sense that so much attention is paid to this data point, but it’s not the only important metric tracking the attractiveness of your company.

When assessing your company’s value, acquirers and investors will often scrutinize your gross profit margin or GPM. As a savvy business owner, you already know how your gross margin impacts your profit, but you should also consider its impact on the future sale of your company to your successors.

How is gross profit margin calculated?

GPM  is the difference between revenue and the cost of goods sold (COGS) divided by revenue. For example, Lola sells a vintage shoe rack from her consignment store in Lenox for $100. It cost Lola $70 to acquire it wholesale, transport it to her store, and refurbish it. That $70 is the COGS. In Lola’s case, her gross profit is the remaining $30 from the sale. Remember that $30 profit is attributed to just that one piece of furniture. The $30 profit does not include the cost of things like rent, utilities, or insurance (those would be used in the net profit margin calculation).

Suppose that the only thing Lola sold to all of her customers was that exact same shoe rack. In that case, Lola’s GPM would be $100 of revenue minus $70 of COGS totaling $30, divided by the revenue amount ($100). In this case, the GPM would be 30 percent. A mix of product and service sales would affect the GPM.

A high gross profit margin is a crucial factor for investors and potential acquirers. It indicates a strong competitive position relative to your competitors. A high GPM is a sign of a unique product or distribution system, strong brand loyalty, or other efficient process that allows the company to charge higher prices or produce at lower costs.

These factors make the company more attractive to acquirers because it demonstrates long-term sustainability and the potential for higher returns on investment.

When a company’s gross margin shrinks, generally, it indicates to investors that the company may be competing on price. For giant companies like Wal-Mart, Southwest Airlines, or Geico Insurance, competing on price could be a positive if they gain market share. However, for small-and mid-tier organizations, a smaller GPM is typically a sign that the business lacks a unique value proposition or marketing differentiation and that competing on price is the only way to attract customers. That shallow moat makes the company vulnerable to competitive threats and less appealing to potential acquirers.

How gross profit margin impacts company value

To illustrate the impact of gross margin on a company’s value, let’s compare two companies: Apple and Intel. Apple’s gross margin is about 44 percent, compared to just 23 percent for Intel. Apple has a solid competitive advantage and a healthy gross margin, whereas Intel’s competitive moat is weaker, and its gross margin is lower.

Apple has a highly differentiated brand and controls the buying experience through its Apple Stores. Additionally, Apple has invested in various high-margin subscription offerings, such as Apple TV and Apple Music. The market is willing to pay more than 29 times Apple’s 2023 earnings (also known as its price-earnings ratio or P/E), and the company has a market capitalization of over $2.5 trillion.

By contrast, Intel, once one of the world’s most prominent companies, has had trouble maintaining its GPM. Once upon a time, consumers rested assured when they bought a computer with the “Intel Inside” sticker affixed to it. Today, Intel offers commoditized technology products, which puts them in a weaker competitive position, requiring them to compete on price and resulting in a lower gross margin. At the end of 2021, Intel had a P/E ratio of 10. The current valuation multiple on Intel is incalculable because it has had negative trailing earnings. Intel’s market capitalization has been nearly cut in half from three years ago.

How your small business’ gross profit margin may be impacting your value

Just as gross margin impacts the world’s largest publicly traded companies, it also impacts smaller businesses. Holt started a plumbing company based in Needham in 2003. Holt ran a lean business and enjoyed healthy gross margins of around 25 percent, generating positive cash flow. Holt invested his earnings to differentiate his company from mom-and-pop plumbing services. He began selling plumbing fixtures and pipes, using an in-hand point of sales system to complete the transaction at the moment of service or repair. Holt then began to sell bathroom and kitchen fixtures out of a showroom, selling service warranties and contracts at the time of those transactions. Holt used a technique called “bundling,” which ties a product and service together to provide better customer value. Holt’s GPM moved up to 35 percent.

Doug owned a nearby mom-and-pop plumbing shop. Before Holt started his company, Doug’s GPM was healthy but ground lower over the years as he lost his competitive advantage. Like many other business owners, Doug recently had to contend with a tight labor market and higher costs.

While Holt’s company grew more substantial and valuable, Doug struggled. In 2023, Doug sold his business to Holt — and not at a price Doug was particularly enthusiastic about.

Many companies raise prices or reduce input costs to achieve a higher GPM. For instance, a company could offer tiered pricing to increase revenue. It could provide multiple versions of its products or services at different price points to cater to various customer segments. Or it could climb the luxury ladder to justify higher prices by offering better quality, improved features, or convenient supply or services. To reduce input costs, it could hire a chief operating officer to focus on internal efficiency. Streamlining production processes and service workflows minimizes waste and improves productivity.

An often-overlooked approach to improving gross margin is to create a point of differentiation for your business in the minds of your customers. When your customers see your business as unique, you are less likely to have to compete solely on price.

Charging a premium for a differentiated product or service will pump up your gross profit margin — and your company’s value.

This article first appeared in the Berkshire Eagle on November 20, 2023.