It's pretty typical for the conversation to turn to investments and ASX shares at a backyard gathering.
People love talking about their winners, and sometimes their losers.
But raising one topic might make you a social pariah, according to US investment expert Brian Feroldi.
"If you attend a barbeque this summer and start a conversation about 'gross margin', you'll get a lot of confused looks. Don't ask us how we know this," he said in his newsletter.
"But don't worry… we think gross margin is perhaps the most under-appreciated investment metric."
In fact, the world's most famous stock investor agrees.
"Warren Buffett is a massive fan of gross margin," said Feroldi.
"It's a metric that he keys in on when he's analysing a business."
Image source: Getty Images
The definition of gross margin
So what exactly is gross margin?
It's a percentage that describes how much money the business keeps after paying for all its costs to make the product or service that it sells.
The formula is: (revenue — cost of goods or service)/revenue
Feroldi took the example of a lemonade vendor selling her drinks at $1 per cup.
"What you hand over to your customer — the water, lemons, sugar, and cup itself — costs $0.40," he said.
"You keep $0.60, giving you a gross margin of 60%."
Why is gross margin so critical?
Other than directly showing you how much money the company is making, Feroldi values gross margin as a metric because the rate of change over time indicates the moat.
"Nothing is more important than establishing a moat in the hyper-competitive business world," he said.
"Think of a moat as an 'unfair advantage' a company has. A company with a moat can provide something to the world that its competition can't."
So if the gross margin grows over time, it suggests the company has a strong moat because it can raise prices without losing customers.
If margins are coming down, then it's bad news on multiple levels.
"It could hint that the competition offers a good-enough alternative for a lower price. And the only way the company can respond to such attacks is to lower its prices," said Feroldi.
"If you now have to sell your lemonade for $0.90 — but the water, lemons, sugar, and cups cost the same — it means you're now only keeping $0.50 per cup — for a 55.6% gross margin."
While going from 60% to 55.6% might not seem like a huge difference, it's a red flag for Feroldi.
"It reveals that customers are price sensitive, indicating that the company does not have a moat, or it is under attack," he said.
"This is why we pay so much attention to gross margin. It's much more revealing about the relationship between the company and the consumer than any other metric."
Admittedly revenue and earnings get all the attention during reporting season.
But Feroldi and many other boffins reckon gross margin is "far more revealing about the true state of the business".
"Of course, gross margin isn't a perfect metric… But the gross margin is an extremely useful number. Train your eyes to look at it first when examining an income statement."
