What is the Price-to-Gross Profit Ratio?
The Price-to-Gross Profit (P/GP) Ratio is a valuation metric that compares a company’s market capitalization or stock price to its gross profit. It offers a more nuanced view than the Price-to-Sales (P/S) ratio because it considers the cost of goods sold (COGS), giving insight into a company’s production efficiency and pricing power.
Formula:
Price-to-Gross Profit Ratio (P/GP) = Market Capitalization / Gross Profit
OR
Price-to-Gross Profit Ratio (P/GP) = Stock Price per Share / Gross Profit per Share
- Market Capitalization: The total market value of a company’s outstanding shares of stock. (Stock Price x Shares Outstanding)
- Gross Profit: Revenue minus the Cost of Goods Sold (COGS).
- Stock Price per Share: The current market price of a single share of the company’s stock.
- Gross Profit per Share: The company’s total gross profit divided by the number of outstanding shares.
Steps for Calculation:
- Determine Market Capitalization: Multiply the company’s current stock price by the number of outstanding shares.
- Obtain Gross Profit: Find the company’s gross profit for the relevant period (trailing twelve months or the most recent fiscal year) from the company’s income statement.
- Calculate the P/GP Ratio: Divide the market capitalization by the gross profit.
OR (Using per-share data):
- Find Stock Price per Share: Obtain the current market price of a single share of the company’s stock.
- Calculate Gross Profit per Share: Divide the company’s total gross profit by the number of outstanding shares.
- Calculate the P/GP Ratio: Divide the stock price per share by the gross profit per share.
Example:
Let’s say we want to calculate the P/GP ratio for “ManufacturingCo”:
- Stock Price per Share: $25
- Number of Outstanding Shares: 5 million
- Total Revenue (Trailing Twelve Months): $100 million
- Cost of Goods Sold (COGS): $40 million
- Gross Profit: Revenue – COGS = $100 million – $40 million = $60 million
Method 1 (Using Market Cap):
- Market Capitalization: $25 (Stock Price) * 5,000,000 (Shares Outstanding) = $125 million
- Gross Profit: $60 million
- P/GP Ratio: $125 million / $60 million = 2.08
Method 2 (Using Per-Share Data):
- Stock Price per Share: $25
- Gross Profit per Share: $60 million / 5,000,000 (Shares Outstanding) = $12
- P/GP Ratio: $25 / $12 = 2.08
In this example, Manufacturing Company’s P/GP ratio is 2.08.
Analysis and Interpretation:
A P/GP ratio of 2.08 indicates that investors are willing to pay $2.08 for each dollar of ManufacturingCo’s gross profit.
- Lower P/GP Ratio: Generally suggests that a company is undervalued or that investors have concerns about its production efficiency or pricing power.
- Higher P/GP Ratio: Typically indicates that a company is overvalued or that investors have high expectations for its ability to control production costs and maintain strong gross profit margins.
Factors to Consider When Analyzing the P/GP Ratio:
- Industry: The P/GP ratio is most useful when comparing companies within the same industry, as different industries have varying cost structures and gross profit margins. Compare Manufacturing Company’s P/GP to other manufacturing companies.
- Gross Profit Margin: Companies with higher gross profit margins (Gross Profit / Revenue) can justify higher P/GP ratios because they are more efficient at converting sales into profit.
- Growth Rate: Companies with high revenue growth rates, especially those achieving improved gross profit margins, may have higher P/GP ratios.
- Competition: The competitive intensity of the industry impacts the P/GP ratio. Companies with strong competitive advantages may have higher P/GP ratios.
- Historical Trends: Track a company’s P/GP ratio over time to identify any significant changes in its valuation relative to its gross profit.
- Business Model: Different business models have varying gross profit characteristics. Compare retailers to manufacturers to technology companies, etc.
Limitations of the P/GP Ratio:
- Ignores Operating and Other Expenses: The P/GP ratio only considers revenue and COGS. It does not reflect a company’s operating expenses, interest expenses, taxes, or other expenses.
- Industry-Specific: P/GP ratios are most relevant for comparisons within the same industry.
- Still Needs Further Analysis: A low P/GP ratio alone is not enough to declare a company a good investment. It requires more research and additional factors to consider.
When to Use the P/GP Ratio:
- Comparing Companies within the Same Industry: This ratio is best used to compare the valuations of companies within the same industry that have similar business models.
- Assessing Production Efficiency: Provides insight into how efficiently a company converts sales into gross profit.
- Valuing Companies with Varying Profitability: A better valuation metric than P/S when comparing companies with widely different gross profit margins.