The degree of profitability is one of the most important measures of a quality of a company. Like any other financial measures, there has been a huge debate over which financial metric is the best measure of profitability. Increase in gross margin is one of the nine criteria of the Piotroski F-Score. Let's discuss why Piotroski selected gross margin as a measure of improved profitability below.
Return on equity (ROE) is the probably the most commonly quoted and used financial metric used to assess profitability, largely because it uses net income and shareholders' equity, which appears to be the most direct and intuitive. However, ROE suffers from a few deadly flaws. First, ROE is not a pure operational measure as it incorporates the impact of financing decisions, i.e. higher leverage boosts ROE.
Second, net income is regarded as a "dirty" number, as it suffers from all forms of accounting distortions and one-offs. The obvious alternative, return on assets (ROA) is independent of capital structure, but is an improper measure as the numerator and denominator are not aligned. Net Income is an equity measure, while both shareholders and debt holders have a claim on the assets of the company.
A measure that has gained traction in recent years is the return on invested capital (ROIC). However, there is no consensus over the calculation of ROIC and the necessary adjustments to the both numerator and denominator.
Also, ROE, ROA and ROIC are impacted by asset turnover, which many perceive to be a function of the industry, rather than specific company strategies or characteristics. Hence, some investors have shown a preference for pure margin-related financial metrics. In particular, EBIT margin, EBITDA margin and free cash flow margin have found followers who have abandoned net margin as a measure of profitability.
Free cash flow margin does not allow for easy comparison between companies, as not all companies generate positive free cash flow in every single year. Both EBIT and EBITDA do not adjust for maintenance capital expenditures and hence cannot be seen as perfect proxies for cash flow.
Gross margin is the best measure of profitability for the Piotroski F-Score because the further up the income statement one goes, the "cleaner" the profitability measures are in a relative sense. Furthermore, it allows an apples-for-apples comparison between two companies in the industry but at different stages in the life cycle. A company in the growth stage of the corporate life cycle will spend more on marketing, research and development, and capital expenditures, which may depress its operating and net margins.
However, gross margin is not perfect, as it may be still blind-sided by accounting rules. Using two U.S. retailers as an example, Nordstrom (JWN) accounts for store leases, buying costs and depreciation as part of COGS, while Macy's (M) account for the same expenses as part of SG&A. As a result, Nordstrom's gross margins appear to be lower than Macy's. Also, it assumes that all investments in marketing, research and development, and capital expenditures contribute to future growth. In certain cases, such spending is "defensive and maintenance" in nature.
Return on equity (ROE) is the probably the most commonly quoted and used financial metric used to assess profitability, largely because it uses net income and shareholders' equity, which appears to be the most direct and intuitive. However, ROE suffers from a few deadly flaws. First, ROE is not a pure operational measure as it incorporates the impact of financing decisions, i.e. higher leverage boosts ROE.
Second, net income is regarded as a "dirty" number, as it suffers from all forms of accounting distortions and one-offs. The obvious alternative, return on assets (ROA) is independent of capital structure, but is an improper measure as the numerator and denominator are not aligned. Net Income is an equity measure, while both shareholders and debt holders have a claim on the assets of the company.
A measure that has gained traction in recent years is the return on invested capital (ROIC). However, there is no consensus over the calculation of ROIC and the necessary adjustments to the both numerator and denominator.
Also, ROE, ROA and ROIC are impacted by asset turnover, which many perceive to be a function of the industry, rather than specific company strategies or characteristics. Hence, some investors have shown a preference for pure margin-related financial metrics. In particular, EBIT margin, EBITDA margin and free cash flow margin have found followers who have abandoned net margin as a measure of profitability.
Free cash flow margin does not allow for easy comparison between companies, as not all companies generate positive free cash flow in every single year. Both EBIT and EBITDA do not adjust for maintenance capital expenditures and hence cannot be seen as perfect proxies for cash flow.
Gross margin is the best measure of profitability for the Piotroski F-Score because the further up the income statement one goes, the "cleaner" the profitability measures are in a relative sense. Furthermore, it allows an apples-for-apples comparison between two companies in the industry but at different stages in the life cycle. A company in the growth stage of the corporate life cycle will spend more on marketing, research and development, and capital expenditures, which may depress its operating and net margins.
However, gross margin is not perfect, as it may be still blind-sided by accounting rules. Using two U.S. retailers as an example, Nordstrom (JWN) accounts for store leases, buying costs and depreciation as part of COGS, while Macy's (M) account for the same expenses as part of SG&A. As a result, Nordstrom's gross margins appear to be lower than Macy's. Also, it assumes that all investments in marketing, research and development, and capital expenditures contribute to future growth. In certain cases, such spending is "defensive and maintenance" in nature.
