Gross Profitability Ratio – The New Magic Formula?

by | Investment Analysis

The Gross Profitability Ratio is gaining credibility in value investing circles as a qualitative metric which provides valuable, if not predictive, analysis. Some analysts argue it is the single best qualitative metric with which to compare multiple stocks (particularly within the same industry) that have already been determined to be bargains.

Gross Profitability Ratio Formula

Gross Profitability = Gross Profit to Total Assets

Where:
Gross Profit = Revenues – Cost of Goods Sold (Income Statement)
Total Assets = The Sum of All Current and Long-Term Assets (Balance Sheet)

Why Gross Profitability is Better

Gross Profit is derived from the top of the income statement and therefore is considered a “cleaner” number than Net Income or EBIT as the numerator. Net Income and EBIT (used in the Magic Formula) can be manipulated or distorted.

Gross Profit is the basics of what a company does. What does the company receive for its product and how much does it spend to produce its product? A company with high gross profit has the opportunity to make wise decisions on how they allocate capital (re-invest, reduce debt, shareholders). A company with low gross profit has a lower probability of being successful.

Total Assets is used as the denominator as opposed to Invested Capital in the Magic Formula. This makes Gross Profitability independent of the capital structure or leverage of the company. The objective is find out how much profit the company’s assets are producing.

Cash actually becomes a penalty in the equation because it increases the denominator (cash is an asset) and lowers the Gross Profitability Ratio. This helps eliminate stocks that may be loaded with cash (and appear on value stock screens) but are not making money with their cash. It is a reasonable argument that this makes the Profitability Ratio perfect to pair up with Enterprise Value Ratios where cash makes the metric more attractive.

In other words, a list of stocks formulated from an Enterprise Value Ratio sorted by the Profitability Ratio provides a list of stocks that have been analyzed by the single best quantitative and single best qualitative metric. This is a powerful means to generate lists of companies that are both cheap and quality.

Additional Reading:  5 Dividend Kings With Highest Gross Profitability Ratio

A Short History of Gross Profitability

Benjamin Graham looked for stocks that were cheap, but wanted to buy quality companies that were cheap. The true bargain is buying a quality company with a cheap stock price.

It’s fairly easy to find cheap stocks. The hard part is finding cheap stocks which will increase in price as investors realize the company has qualities that were not recognized in the stock price.

Robert Novy-Marx searched for a qualitative metric which would pair well with value metrics. He released a working paper in 2010, and a revised version in 2012, detailing the in-depth study on Gross Profitability including empirical evidence to back up his findings. For those interested in getting really deep into the subject you can find the study here:

The Other Side of Value: The Gross Profitability Premium

A far more simple and understandable study can be found on the Fat Pitch Financials Website:

Gross Profits to Assets Ratio Backtest

George’s backtest provides substantial evidence that companies with low gross profitability scores underperform companies with high gross profitability scores. This is true for every quintile; adding additional credence to the findings.

Related Reading: Bargain Dividend Stocks: Screening For Quality With Gross Profitability Ratio

Conclusion

A high Gross Profitability Ratio is evidence that a company has sustainable competitive advantages. Otherwise competition would enter their business and lower their profits. The fact they have above average profits means they are able to execute a superior or favorable position over their competitors.

This “magical” ratio is my favorite metric to apply to stocks I have already determined to be cheap. It is the best measure of the productivity of the company’s assets.

The idea is to combine value and quality metrics to find quality stocks whose price is a bargain. The most efficient approach is finding cheap stock first, then screen those stocks for quality with the Gross Profitability Ratio. Try it, you’ll like it. It works, and that is all that matters!

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Disclaimer
While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.

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