This post is part of an ongoing series where I practically walk through important calculations, metrics and unit economics for consumer internet businesses. First up, income statement and margins.
Inconsistencies around "margins" are something that I come across every week. Metrics such as GMV, revenue and EBITDA are cited often, but there is frequently confusion around what these metrics really mean. I've also seen many inaccurate comparisons and benchmarks for these metrics given that they vary from company to company and aren't always apples-to-apples. Let's clarify:
GMV is the top level metric for many businesses. It stands for gross merchandise value, but could also be synonymous with terms like total order value, total dollars processed and gross revenue. GMV is a relevant metric for your business if there are dollars flowing through the platform that are not necessarily booked as direct revenue. For earlier stage businesses where this sometimes may be the only meaningful metric, it's important to understand that these businesses will ultimately be valued on revenue and profitability, not "GMV". If you look at the filings for companies like Amazon, Ebay and Etsy, you will find that they are valued on revenue, not GMV or transaction volume. GMV is a great metric to look at, but it's even more important to understand revenue take-rate followed by gross margin.
Revenue is the level of sales that the business is generating. It's arguably a more important top-level metric than GMV, particularly when GMV isn't even relevant. If there is some portion of the revenue that will be automatically owed to a vendor or supplier, then that is probably GMV, NOT revenue.
Gross margin is just revenue less any cost of goods sold (COGS), which are variable costs. To calculate "gross margin %", take gross profit and divide it by revenue (NOT GMV). Gross margins show the amount of profit before operating costs such as marketing, overhead and salaries. It is a proxy for the profit potential of a business. You may have negative EBITDA and net income, but if you have a decent gross margin, then perhaps as your business scales you will be able to cover your overhead with your gross profit and eventually become cash flow positive.
Operating costs include line items such as sales & marketing, overhead, payroll, travel expenses, etc. These are costs associated with running your business, unlike COGS which are the costs DIRECTLY attributable to delivering your product or service. A company with good "operating leverage" is one that has decreasing operating costs as a % of revenue over time. Take your gross margin and subtract operating costs to calculate operating profit, otherwise known as EBIT.
This is an adjustment of gross margin which I sometimes call "true gross margin". Take your gross margin and also load in any operating costs which seem like they are more variable than they are fixed. In other words, are there any operating costs that should be allocated to COGS? For an ecommerce company, you will want to include a pro-rated amount of costs for items such as returns/refunds, customer service, etc. These costs should be brought above the gross margin line in order to better understand if a company has a working business that can be profitable in the long run.
Sample P&L for Company X: Food Ordering Marketplace (like GrubHub)
In the above example, while the company generates $2.5B of GMV, the actual revenue to the company is $375M. Gross margins are quite high at 70%, yielding $263M of gross profit. After you load in all of the operating costs, you are left with $93M in operating profit, a modest amount compared to the $2.5B GMV at the top! If you wanted to be really precise, then could add in a contribution margin line below gross margin and further "burden" the gross margin with some additional operating costs that are directly associated with an incremental order.
I'll stop there. Generally, those are the most important top-level metrics to understand. When comparing valuation multiples between companies, it is extremely important to make sure you are comparing metrics properly. GMV should be compared to GMV, revenue should be compared to revenue, etc. There are also other important metrics such as EBITDA, net income, cash flow and others. However, for very early stage businesses, the aforementioned metrics are crucial. In my next posts, we will take these metrics and use them to better understand unit economics, LTV and payback.