EV/Gross Profit Ratio

What Is The EV/Gross Profit Ratio?

The EV in EV/Gross profit ratio (EV/GR) stands for the enterprise value, where the quotient finds the company's profitability through its gross profit. In other words, this ratio finds the number of dollars of the enterprise value increased per every dollar of GR acquired.

In this sense, a lower ratio means the company is potentially undervalued, which is ideal. The calculation is done by finding the percentage of enterprise value concerning the company's gross profit through an annual-by-annual approach.

The ratio measures a company's profitability by analyzing the relation between value and profit, indicating whether a company is potentially undervalued or overvalued.

Furthermore, this also helps to assess fair value, the unbiased estimate of the market price of a product or asset's worth.

The EV cannot be negative unless the cash balance is greater than the market cap, debt, and preferred shares combined, which is beneficial because you can buy the entire firm for less than its cash on the books.

There are other measurements to assess a company's enterprise value with additional financial information, including EV/EBITDA, EV/Revenue or EV/Sales, and EV/Market Capitalization. Remember that EV/GR includes revenue and market cap in its calculations.

What is enterprise value?

To understand the concept of the ratio, we need first to grasp the idea of enterprise value. By definition, EV means a company's total value, like net worth or net capitalization.

This value includes the company's market capitalization and short-term and long-term debts, less any cash on the balance sheet.

The EV is a metric commonly used by investors and other organizations for evaluations and potential takeovers.

Additionally, the enterprise value looks beyond the equity value but rather the entire market value, including debt and equity, that would perk ownership interests by portraying a theoretical price of the company.

The EV is especially used during Merger and Acquisition (M&A) processes in assigning and transferring ownership. The value helps to determine a general sense of the acquisition prices and references the relative performances of different companies, like valuation multiples.

Some of the things that this value tells investors, companies, and acquirers include the following:

1. Deal premium: the difference between the approximated real value and the price paid for the acquisition of a company. 
2. Supply and demand: a fundamental economic principle heavily involved in the stock market and changes in the share price. 
3. Competitive bidding: multiple companies are trying to acquire one company can drive up the acquisition price and premium.

Calculating EV/Gross Profit Ratio

To calculate the EV, we can assign the variables to the following definitions before we come to an equation:

• MC = Market capitalization, which is calculated by multiplying the current stock price with the number of outstanding stock shares
• TD = Total debt or the sum of both short-term and long-term debts.
• C = cash and its equivalents that fall under the liquid assets category; this does not include marketable securities
• EV is the sum of market capitalization and total debt minus the cash and cash equivalents, expressed as such:

EV = MC + TD -C

Make sure to refer to the balance sheet when calculating the company's total debts. Variations in debt identification include market value, net, or outstanding debt.

Other equations also include preferred stock (PS) and minority interest (MI) in the sum equation as such:

EV = MC + TD + PS + MI-C

Components of EV/Gross Profit Ratio

Let us understand the ratio better by going through its component one-by-one:

1. Market Capitalization (MC)

To find the market capitalization, we can use the equation below by using the stock market and balance sheet for the data on price per share and paid-up equity shares, respectively, to find the product that results in the MC value:

Market Capitalization = Current price per share* Outstanding number of paid-up equity shares

When companies acquire another company, they usually pay above the value derived from the MC calculation.

2. Total Debts (TD) or Outstanding Debt

Available on the balance sheet, the outstanding debt is the sum of bank loans and corporate bonds, both of which are liabilities to a company:

Outstanding debt = Bank loans + Corporate bonds

The above equations include the banks' and creditors' involvement in addressing liabilities and assumed debt. If the market value of the debt is undisclosed, the company that acquired the other company will pay according to the book value of the debt.

3. Preferred Stock (PS)

This is also available on the balance sheet, where the per value of stocks and the number of outstanding preference shares are recorded for reference. The product of the two components yields the preferred stock value:

Preferred Stock = Par value * Outstanding number of preference shares

Please note that preferred stocks include both equity and debt components, making them hybrid securities, although they resemble debt more than the former. During the M&A process, the buyer would pay them like debt.

As the name entails, they are higher prioritized in claims for asset and earning management and documentation. This type of stock is also less risky than common stocks as the holder would receive fixed dividends with a fixed annual return, regardless of the profitability of that year.

4. Minority Interest (MI)

As for minority interest, also known as non-controlling interest, its number is on the balance sheet.

The concept of minority interest is when there is partial ownership in the company, as the parent company owns most shares.

5. Cash and Cash Equivalents (C)

We can arrive at the value for cash and cash equivalents by computing the sum of two components, cash balance and fixed deposits and current account deposits with banks, as indicated below:

Cash and Cash Equivalents = Cash balance + Fixed deposits and current account deposits with banks

Cash and cash equivalents are liquid assets, and examples include short-term investments (e.g., government bonds with a maturity date of fewer than three months), commercial papers, money market funds, treasury notes and bills, marketable securities, and certificates of deposit.

Enterprise Value (EV) Example

Let us say we want to find the enterprise value for Company A, and its financial information is detailed as follows:

• Number of shares outstanding: 2,750,000
• Current price per share: $5.00
• Total debt: $4,500,000.00
• Total cash: $1,800,000.00

We can then infer from the above information that there is no preferred stock or minority interest at play for our succeeding calculations for EV value.

Here is a list of the formulas:

Market Capitalization = Current price per share* Outstanding number of paid-up equity shares

Outstanding debt = Bank loans + Corporate bonds 

Preferred Stock = Par value * Outstanding number of preference shares 

Cash and Cash Equivalents = Cash balance +Fixed deposits and current account deposits with banks

In practice:

Market capitalization = $5.00 * 2,750,000 = $13,750,000.00

Preferred stock = $0.00

Outstanding debt = $4,500,000.00

Minority interest = $0.00

Cash and cash equivalents = $1,800,000.00

EV = $13,750,000.00 + $0.00 + $4,500,000.00 + $0.00 - $1,800,000.00

EV = $16,450,000.00 or $16.45 million

We conclude that Company A has an enterprise value of $16.45 million.

What is gross profit (GP)?

Gross profit, also referred to as gross income, stands for the total profit of a company after subtracting costs associated with supplying goods and products, the overall production, selling, and distribution networks and channels.

The GP value is on the income statement as it indicates and measures a company's profitability and financial outlook. Furthermore, it is also a metric used by the business to evaluate its performance and investors to see the potential in supporting the business.

The determined profitability also helps to show the contributing roles played by variable costs that are dependent on the output levels or demands on the consumption market of the company. Some examples of these variables include:

• Raw material
• Piece-rate labor 
• Production supplies
• Delivery and shipping costs 
• Commissions for sales 
• Direct labor dependent on hourly pay or output levels
• Credit card fees
• Packaging and equipment costs 
• Production line necessities dependent on hours of operation

Keep in mind that the gross profit does not include fixed costs that are independent of output levels like costs for rents and leases, salaries that are fixed, utilities, insurance, marketing or advertising, supplies or machinery, and loan repayments.

Also, GR is not operating profit, where the operating profit only deducts operating expenses from the gross profit and does not include the cost of goods sold in its calculation process.

The formula for finding the gross profit value is determined as such:

Gross Profit = Revenue - Costs of Goods Sold

The revenue would be in the sales section on the income statement, whereas costs of goods sold would be abbreviated as COGS.

EV/Gross Profit Ratio Example

Assume that the revenue and COGS are distributed below as follows for Company A:

We can then use the values presented in the table to calculate the gross profit value and the gross profit margin for Company A.

Using the equation previously mentioned, we can subtract the COGS from the various sources of costs and expenses from the total revenue generated by the company as follows:

$16,425,000.00 -$ 12,460,000.00 = $3,965,000.00

This means that Company A has a gross profit value of $3.965 million.

However, when obtaining the gross profit margin, we need to express it in a percentage format in relation to the total revenue with the following equation:

Gross Profit Margin = (Gross Profit / Total Revenue)

By plugging in the values we calculated earlier, we can find the margin as follows:

($ 3,965,000 / $16,425,000) * 100% = 24.14%

This means that Company A has a gross profit margin of 24.14% – an exceptional rate that exceeds the “good” margin threshold of 20%, considering that most businesses fall within the 5% to 10% range.

How to calculate the EV/Gross Profit Ratio? Using the equations we have earlier, we can calculate the ratio:

EV = MC + TD + PS + MI-C

Gross Profit = Revenue - Costs of Goods Sold

So the ratio =

MC + TD + PS + MI - C /Revenue - Costs of Goods Sold

Suppose we use Company A as the example, which has an EV of $16,450,000.00 and a gross profit of $3,965,000.00; the ratio would be roughly 4.15.

Improving gross profit margins

To increase gross profit margins, companies can find ways to become more efficient and effective in managing their finances while maintaining a consistent output level to meet the demands.

For instance, efficient inventory management would help drive down the costs needed to produce goods and, therefore, could yield larger profit margins, which could be used for product development purposes or repaying debt obligations, if applicable.

Another approach is to increase prices, although evaluating where the equilibrium lies between supply and demand is necessary to determine the optimal price point to prevent the loss of demand or customers.

Investing in product lines to increase the productivity and work rate of employees and machinery alike can help make productions more convenient, therefore being capable of serving a larger customer base, addressing a higher demand, and having fewer capability constraints.

In short, maximizing the difference between revenue and COGS would increase the margin: either find ways to increase revenue, such as developing a competitive advantage, offering incentives or attractive marketing campaigns or reduce COGS like production and delivery.

References by industry: Averages for gross profit margins are listed below for several industries.

Please note that the gross margins vary drastically for different types of businesses and industries:

*The numbers for total market calculations includes industries not listed above.

Researched and authored by Max Guan | LinkedIn

Reviewed and Edited by Aditya Salunke | LinkedIn & Divya Ananth | LinkedIn

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