“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 by 10 percent, then you’ve got a terrible business.” – Warren Buffett

I added a column within the Google Spreadsheet Watchlist for “Pricing power”, with the ranking system of 1 to 5 – 1 being weakest and 5 being strongest. This provides an important reminder for myself when evaluating companies, that sufficient pricing power itself can be a margin of safety and may invite unexpected upside.

The beauty of true pricing power acts in such a way that a company can raise its prices (revenue) without a corresponding increase in its cost base (expenses). In other words, the extra boost in revenue falls directly to the bottomline and provides a magical boost to profits without lifting much of a finger. As a simplified example, a company that makes $100 in revenue by selling widgets currently has a cost base of $95. This translate to a net profit of $5. Assuming that it has a significant amount of pricing power so much so that it is able to raise the price of its widget by 20% without losing a single customer, its revenue is now $120 for the same volume of products sold. The cost of manufacturing its widgets and other miscellaneous costs continue to be $95. Instead of earning a net profit of $5, the company now earns $25 ($120 – $95). This effectively means that profits multiplied by 400% (from $5 to $25) even though revenue only increased by 20%.

Imagine now that the company is publicly-listed and was trading at a P/E multiple of 10 times. When it initially earned $5 in net profit, the stock price was $50 ($5 x 10). After flexing its pricing power muscle and assuming its P/E multiple remained at 10 times, its net profit of $25 now translates to a stock price of $250 or a 4 times gain if you sell the stock at this point. If the market decides that it previously overlooked the “hidden” pricing power the company has, that perhaps a 10 times multiple is too low for such a strong business, and that a 15 times P/E multiple is probably more fitting (multiple re-rating), the stock price goes up to $375. From the initial stock price of $50 to $375, one would have made 6.5 times his money from the benefit of a company’s pricing power and the market’s recognition of it.

In the real world of course, the perfect situation of a company as described above is probably rarer than a unicorn, given that most people would have easily recognised the strength of such a business, so much so that the multiple would be way higher than 10 times. Even though it is an extreme example, I hope it clearly illustrates the extra rocket fuel an investment can provide if the underlying business has sufficient pricing power, and given the skewed positive returns it can provide, paying up for quality businesses even at higher multiples can sometimes be very worth it.

The most recent types of businesses or more specifically, a company that has been in the limelight for all the wrong reasons by taking pricing power to the extreme is none other than the pharmaceutical company, Valeant. It worked well for awhile before it all came crashing down when enough people decided Valeant had gone too far in raising its products’ prices. The underlying lesson is that to build a sustainable business, a company that is able to raise its prices above the rate of inflation with such ease without losing a single unit volume, should probably use this privilege sparingly to avoid alienating its customers and risk damaging its long-term viability.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s