Gross Profit Margins: Why 70% Is Often a Useful Benchmark
- Max Teh
- 11 hours ago
- 4 min read
Updated: 38 minutes ago
KEYPOINTS:
🔑 Favor businesses with high Gross Profit Margins (preferably ≥70%), as they often indicate stronger pricing power, differentiated products, and superior unit economics.
🔑 Companies with low Gross Margins (≤40%) tend to face structural limitations, making it harder to scale profitability and often leading to higher valuation risk during market corrections.
🔑 Gross margin should be evaluated contextually by industry, but in general, higher gross margins tend to translate into stronger operating margins, profitability, and free cash flow over time.
Table of contents
Disclaimer: This communication is provided for information purposes only and is not intended as a recommendation or a solicitation to buy, sell or hold any investment product. Readers are solely responsible for their own investment decisions.
One of the simplest yet most powerful financial indicators investors can examine when analyzing a business is Gross Profit Margin (GPM).
While there are many financial metrics available, gross margin often reveals something very fundamental about a company’s business model - its pricing power and structural economics.
As a general guideline within my investment checklist, I prefer to favor companies with gross profit margins of 70% or higher, and aim to minimize exposure to companies where gross margins are below 40%.
This guideline is not meant to be an absolute rule, but rather a useful signal when evaluating the structural quality of a business.
Why Gross Margin Matters
Gross margin represents the percentage of revenue a company retains after covering its direct costs (cost of goods sold).
A higher gross margin typically indicates that a company:
• Has strong pricing power
• Possesses differentiated products or services
• Operates with structurally stronger unit economics
Companies with high gross margins tend to have more room to absorb operating expenses such as R&D, marketing, and administrative costs, while still maintaining healthy profitability.
This is why many of the world’s strongest compounders tend to operate with structurally high gross margins.
Some examples include companies such as Meta Platforms, Qualys, and Fortinet, all of which maintain gross margins above 80%.
Even luxury brands such as Prada also benefit from structurally high margins due to strong brand power.
These businesses often convert their strong gross margins into high operating margins and free cash flow over time.
Why This Is Especially Important For Companies That Are Not Yet Profitable
This checklist becomes even more relevant when evaluating companies that are not yet profitable at the EBITDA or EBIT level.
For these companies, investors often rely on valuation multiples such as:
• Price-to-Sales (P/S)
• EV/Sales
• EV/Gross Profit (EV/GP)
When a company has high gross margins, each dollar of revenue generates significantly more gross profit.
This allows the company to scale toward profitability much more easily as operating expenses stabilize.
On the other hand, companies with low gross margins often require far larger revenue growth before they can achieve meaningful profitability.
The Valuation Risk of Low Gross Margin Businesses
Companies with gross margins below 40% often face a different valuation dynamic.
Because each dollar of revenue produces relatively little gross profit, investors sometimes end up valuing these companies on EV/Gross Profit multiples that appear elevated.
For example, companies such as Grab Holdings and Spotify Technology traded at relatively elevated EV/GP multiples during certain periods.
When the overall market environment is optimistic and liquidity is abundant, these types of companies may perform well.
However, when market sentiment tightens, stocks with high valuation multiples relative to their gross profit generation may become more prone to correction.
Another challenge arises when these companies begin transitioning toward profitability.
Even when EBITDA or EBIT starts to stabilize, valuation multiples such as EV/EBIT may remain elevated for some time, which can create further downside pressure on the stock.
Why The 70% Guideline Should Be Viewed Contextually
It is important to note that the 70% gross margin guideline is most applicable to software and asset-light digital businesses.
Many SaaS and software companies naturally operate within this range due to the scalability of their products.
However, certain exceptional businesses may still possess strong competitive advantages despite having lower gross margins.
For instance, companies with highly specialized technological monopolies such as ASML Holding operate with gross margins around 50%, yet still possess extraordinary economic moats.
Similarly, some consumer businesses may gradually move toward higher margins over time as their brands strengthen.
Companies like Pop Mart are examples of businesses that are steadily improving their margin profile as they scale.
Industry Context Still Matters
In certain industries, lower gross margins are simply structural characteristics of the business model.
For example, most airline companies operate with gross margins below 40%.
Even the strongest operators within the industry such as Singapore Airlines still fall within this range.
This does not necessarily mean there are no investable opportunities within these industries.
Rather, it simply means investors should be aware that these businesses are structurally different from high-margin compounding models.
Returns in these industries often depend more on cycle timing, operational execution, or valuation discipline, rather than structural margin expansion.
A Useful Signal, Not An Absolute Rule
Ultimately, gross margin should not be viewed in isolation.
However, as a simple screening heuristic within an investment checklist, it can provide valuable insights into the structural economics of a business.
As a general guideline:
• ≥70% Gross Margin → Strong structural economics
• ≤40% Gross Margin → Requires greater caution
Companies with higher gross margins often possess the ability to translate revenue growth into operating profits and free cash flow much more efficiently over time.
For long-term investors seeking durable compounders, this can be a meaningful advantage.
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