So often investors and entrepreneurs look at the wrong financial numbers and ratios when analysing companies. They focus obsessively on the latest year’s pre-tax profits, or perhaps post-tax earnings. But these can often be manipulated, or temporary. What matters much more are underlying sales, strong gross margins and free cash flow. Study these numbers over several years to see if a business really owns a solid franchise.
When an enterprise enjoys consistently solid sales as a percentage of capital employed, and high gross margins, then it should by rights make a decent bottom line and an attractive return on investment. And by high gross margins, I mean 60 per cent or more. Companies that enjoy this scale of margins – and keep their fixed costs within reasonable boundaries – should prosper.
Of course, companies with huge mark-ups over their raw costs are more vulnerable to being undercut by discounters. But it is always better to start with a lot of margin than a low gross margin. When I was involved with PizzaExpress and Strada, I learnt that the pizza business offers spectacular margins, better than anything else in the restaurant trade. Given the way menu prices have risen relentlessly, the major chains must enjoy gross margins of at least 80 per cent on their pizza, or a mark-up of 400 per cent over cost. Yet surprisingly, no one has come in to undercut them and offer a comparable product at half the price.