The popularity of stock investing in recent decades has led to the widespread use of financial ratios to evaluate companies’ performances. However, these are merely mental shortcuts that should be more carefully evaluated – especially since the Investor Relations departments of listed companies are also aware of the signals that published ratios would give investors.
Gross margin looks very simple on the surface and is typically calculated using the formula: (Revenue – COGS)/Revenue. For example, the general rationale behind this ratio is to measure if a company is efficient in its production processes, leading to more sales flowing down to the bottom line.
Yet if a company has significantly stronger gross margins as compared to its peers – it might be important to look at the details and find out the reason why. While there is a chance that the company really has superior gross margins, the difference could be due to different accounting treatments of expenses (such as depreciation) – which could be lumped into either COGS or SG&A. In such a scenario, the underlying cost efficiency might be the same, yet published gross margins may differ significantly.
Among the two favourite things management could do, namely dividends and share repurchases, the latter is often taken as equivalent to the first. After all, buying back your own stock could be taken to be a boon for investors.
What many investors might not notice is that this also changes important valuation ratios, such as P/E or P/B. By reducing the number of shares outstanding, the denominator (Earnings per share) is actually higher, which leads to a lower P/E. Although nothing about the underlying company’s fundamentals has changed, the company actually looks cheaper to an investor looking for companies with lower P/E ratios.
In general, good earnings numbers lead to better stock prices and better compensation for management and employees. However, sometimes companies overinflate earnings using accounting techniques that don’t necessarily reflect an improvement in the underlying fundamentals.
For example, depreciation expenses can be easily adjusted to improve the bottom line. By modifying depreciation methods, artificially inflating asset salvage values, or classifying certain types of depreciation under different categories, profit margins can deliberately be made to look better than they really are.
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