“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price 10 percent, then you’ve got a terrible business.”
Buffett loves companies with wide moats, and pricing power offers a way to determine whether a company carries a moat or not.
For example, Coke’s ability to raise prices over the years or Apple’s intense demand for their iPhones allows them to raise prices without damaging demand.
We will provide several qualitative methods to evaluate pricing power and imply that most businesses find it challenging to raise prices over time to keep up with inflation, even though this remains difficult to determine empirically.
But finding companies with the pricing power to carry them through periods of inflation will offer better long term results, which remains our goal.
In today’s post, we will learn:
- What is Pricing Power?
- Who Has Pricing Power?
- What Affects Pricing Power?
- How to Measure Pricing Power
- How Pricing Power Works in Porter’s 5 Forces
- Investor Takeaway
Okay, let’s dive in and learn more about pricing power.
What is Pricing Power?
Pricing power is a concept used in economics to describe how changing a firm’s product price affects the amount of demand for that product.
Price elasticity of demand and pricing power are related. We can measure the degree to which people, consumers, or producers alter their demand or the volume supplied in reaction to price changes by price elasticity.
For instance, if a product’s price increases, it is likely that fewer people will want to purchase it as they will look for less expensive alternatives.
Analysts and experts focus a lot of their time on determining pricing power for companies. For example, on a recent earnings call focusing on SP Global (SPGI), which offers ratings, data, and research of the 20 analyst questions, eight of them focused on pricing power.
Pricing power helps drive company growth, particularly when the company has a strong product or service.
For example, Adobe has built a strong moat around its PDF business. Because of that strength of need, it allows Adobe to raise prices on their PDF products, leading to larger gross profit margins for the company, and ultimately, bigger profit margins.
Who Has Pricing Power?
A price increase will reduce demand for a company’s products if it does not have considerable pricing control. A business that offers a rare or unique product with few competitors on the market has significant pricing power.
A few companies that spring to mind of those with pricing power:
- Moody’s (MCO)
- Adobe (ADBE)
- Disney (DIS)
- Coca-Cola (KO)
- Apple (AAPL)
Some industries often associated with pricing power include:
- IT services
- Food products
- Leisure products
- Many others
Because there are no competing items available to consumers in this situation, the company’s price rise may not significantly impact demand.
Think about the potential for pricing power for Disney. They don’t have much in the way of competitors for their parks, which allows Disney to adjust prices regularly without impacting demand for the parks.
Another example is Apple’s considerable pricing power when the iPhone was first released since it was the only firm providing a smartphone and related software. There were no competing products at the time, and iPhones were pricey. The iPhone continued to dominate the upper end of the market in terms of price and perceived quality even when the first rival smartphones appeared. Apple’s pricing power decreased as the rest of the market caught up in terms of service, quality, and availability of apps.
Because Apple started to provide additional types of iPhones, including more affordable models for people on a budget, the iPhone did not disappear from the market as more competitors appeared.
What Affects Pricing Power?
Pricing power has many factors impacting its effectiveness. For example:
- High barriers to entry
- Industry concentration
- Industry capacity
A resource’s or raw material scarcity has a much greater impact on pricing power than the existence of rivals who sell similar goods.
For instance, even though there are competitor suppliers on the market, certain threats, such as disasters that put the oil supply at risk, result in increased prices for petroleum businesses. Oil has a limited supply, and many other businesses rely heavily on it; therefore, oil firms continue to have a substantial amount of pricing power.
Other industries display tremendous pricing power when there is great demand and little supply. The hospitality, transportation, and travel sectors frequently raise their lodging and services prices during busy holidays or major events. This practice is known as dynamic or surge pricing.
High barriers to Entry
Low entrance barriers typically imply less pricing power and more price competition, while high entry barriers typically imply more pricing power and less price competition.
Due to the low entrance requirements and high levels of competition in the restaurant business, most new establishments close within the first few years.
On the other hand, credit card networks have significant entry barriers and can maintain pricing that allows them to generate exceptional returns on their capital investments.
This link between entry obstacles and pricing power has several outliers, and there are a few explanations for the oddities.
First, because the industry is founded on the sale of a commodity or because the industry’s products have readily accessible competitors, customers may have tremendous price power even in sectors with high barriers to entry.
Second, because it can be difficult to leave some sectors, their owners are enticed to keep running their unproductive businesses. This is because they find it difficult to transfer their cash to another industry. The airline business is one illustration.
Finally, it’s necessary to remember that entry barriers frequently change over time; thus, it’s crucial to be forward-looking in all assessments.
Industry concentration is typically a reliable sign of pricing power and competitive rationality. Fragmented sectors frequently experience intense competition because:
- There are too many rivals to monitor each one individually.
- Small increases in an industry participant’s market share could significantly influence its profitability.
- Instead of considering themselves as part of a wider group, the fragmented players think on an individual level.
The trucking industry offers the perfect case of a fragmented industry.
On the other hand, concentrated industries may more easily coordinate with their rivals and have considerably less to gain by engaging in a pricing war.
Concentrated sectors without pricing power are typically capital-intensive, have significant exit obstacles, and focus primarily on selling undifferentiated commodities as goods or services. The soda industry, where Coca-Cola and PepsiCo have a global market share of well above 80%, is an example of a concentrated industry.
Participants have more pricing power when capacity is constrained or limited, but overcapacity results in price cuts and a fiercely competitive market as excess supply chases excess demand.
Although we must take into account future capacity, current capacity is crucial, as well as examining the length of time it takes suppliers to respond to changes in demand. Hard assets may take years to build or construct and only serve one purpose, whereas liquid money remains easily repurposed to achieve higher profits.
How to Measure Pricing Power
The best measures of pricing power remain gross margins and return on invested capital.
There are many different ways that pricing power operates. Not all brands offer pricing power, and not all instances of pricing power originate from the same place.
Gross margin offers the strongest quantitative measure of a company’s pricing power, computed as [(revenue – the cost of goods sold)/revenue]. Although other non-price elements like volume, cost-effectiveness, product mix, and channel mix also impact gross margin, it is only natural for businesses with significant pricing power to increase their gross margins over time.
“Gross profitability is a measure of a company’s ability to make money. Robert Novy-Marx, a professor of finance at the Simon Business School at the University of Rochester, defines gross profitability as revenues minus cost of goods sold, scaled by the book value of total assets. In other words, gross profitability is gross profit divided by assets. Investors can use gross profitability as a proxy for quality and it is not positively correlated with classic measures of value.”
While the sources of pricing power differ from industry to industry and occasionally from firm to company, they all share the same flaw: they cannot sustain pricing power by market position alone. Companies must continuously enhance their customers’ value to maintain pricing power.
A filter for gross profitability may also be helpful when looking for appealing equities.
Compared to a price-earnings (P/E) ratio, the most popular statistic analysts use to value businesses, profitability can offer a different signal. Gross profitability can make a stock that is unappealing using P/E multiple look attractive, and vice versa for a firm that is unattractive when using a P/E multiple.
Take Amazon as an example. In 2015, the stock had a trailing P/E ratio of about 540 based on a price of $676 on December 31 and $1.25 in reported full-year earnings per share. For comparison, during the same time period, the P/E multiple for the S&P 500 was 20. Based on just its P/E ratio, Amazon’s valuation seemed high.
The gross profitability of the business revealed a different picture. With a gross profit of $35 billion and total assets of $65 billion, Amazon.com had gross profitability of 0.54 in 2015. Gross profitability of 0.33 or greater, in Novy-Marx’s opinion, is normally desirable.
Not only did Amazon’s current gross profitability comfortably surpass that bar, but it has consistently done so for most of the company’s existence.
The standard bar for companies with pricing power is 33%, but each industry or company might operate above or below the figure. Remember, companies with pricing power will maintain or grow gross margins over long periods. The growth is a great sign of a company with pricing power.
Below is a list of companies with pricing power and their gross margins:
Moet Hennessy/Louis Vuitton
SP Global (SPGI)
The second quantitative pricing power measure is the return on invested capital (ROIC).
ROIC allows investors to find companies who reinvest their capital efficiently. The greater the efficiency, the more power and growth the company generates. For example, Apple generates high gross margins and very high returns on invested capital, which tells us Apple has a strong moat.
Companies associated with strong moats like Apple, Nike, Coca-Cola, and Amazon typically have strong pricing power. The above companies also own strong brand power, which means we can never underestimate the strength of the brand and its relationship to pricing power.
Before he pulled the trigger, Coke offered many attractive characteristics to Buffett. Among them:
- Brand power
- Wide moat with high ROIC ratios
- Big gross margins indicative of strong profitability
All of these convinced Buffett that Coca-Cola would have pricing power.
Sorting companies by high ROICs and gross margins can help you narrow down a list of companies offering potential pricing power. For example, try looking for companies with an ROIC > 20% and gross margins > 33%.
For example, Adobe currently carries gross margins of 88.18% and an ROIC of 27.13, indicating a wide moat and possible pricing power. Another, Moody’s, offers gross margins of 73.67% and an ROIC of 39.63%, respectively.
How Pricing Power Works in Porter’s Five Forces
“Strategy is about making choices, trade-offs; it is about deliberately choosing to be different.”
We can analyze an industry’s vulnerabilities and strengths using Porter’s Five Forces, a model that identifies and examines five competitive forces that affect every industry. We can identify the structure of an industry using the Five Forces analysis to develop a company strategy.
Any economic sector can benefit from using Porter’s model to analyze industry rivalry better and increase long-term profitability. Michael Porter created The Five Forces as a professor at Harvard Business School.
Porter’s Five Forces:
- Competition in the industry
- Potential of new entrants
- Supplier power
- Customer power
- The threat of substitute products or services
Pricing power impacts the industry competition. The number of competitors and their capacity to undercut a firm are the first of the Five Forces. The power of a corporation lessens as the number of competitors and the number of comparable goods and services they provide increases.
Suppliers and customers will look to them if a competitor can provide a better deal or lower rates. On the other hand, when there is little competition, a company has more negotiating power and can raise prices to boost sales and profits.
Companies with pricing power can hold off competitors and discourage others from joining the sector. For example, with the stranglehold both Coke and PepsiCo have on the beverage industry, it’s incredibly difficult to break into the sector. The beverage industry continues to be competitive among the remaining 20%, with cutthroat tactics like offering cheaper and cheaper products to entice customers.
Competitive industries, like the beverage industry or streaming, become a race to the bottom, with each competitor attempting to lowball the other. But they become a dangerous game because the costs overcome the profits and the companies go bankrupt at some point.
Pricing power remains one of the more powerful forces in the market, and finding companies with long-term pricing powers relate to finding unicorns.
These companies offer investors great investments because of their great economics and profitability. Companies that generate high gross margins and returns on invested capital tend to have great market returns over longer periods.
Charlie Munger likes to focus on companies with strong pricing power because those companies offer levers to great returns without much effort. For example, when Coke raises its prices to offset commodity pricing impacts, it allows Coke to maintain its margins and profitability.
Not all companies have the power to raise prices during high inflation, and that remains one of the separators between good and great companies.
And with that, we will wrap up our discussion on pricing power.
Thank you for taking the time to read today’s post, and I hope you found something of value. If you have any questions or if I can be of any assistance, please don’t hesitate to reach out.
Until next time, take care and stay safe out there,