According to Warren Buffett (Trades, Portfolio), "The single most important decision in evaluating a business is pricing power." That being said, pricing power is also believed to be a survival mechanism in the high-inflation environment that we are now in.
When searching for companies with high pricing power, I felt I lacked understanding of the concept, which led me to question what pricing power is and how it can be measured. I hope this discussion will help investors understand it as well.
What is pricing power?
Defined as the ability to raise prices without negatively impacting demand, pricing power is usually linked to price elasticity. However, this link is not fully justified for an individual investor.
While price elasticity usually refers to broad market categories, such as electronics or personal vehicles, pricing power deals with a concrete business and its concrete product that possess certain qualities that affect its relationship with customers. For example, the fact that price elasticity of demand for raw potatoes is low does not make a producer of potatoes possess high pricing power. Additionally, the term price elasticity of demand is very sensitive to "the chicken or the egg” dilemma, because both are driven by changes in demand and it is not possible to distinguish what the primary source of change was. Consequently, the use of price elasticity as an analytical tool is not justified for an individual value investor - it simply does not add anything to the analysis performed in evaluating pricing power for an investment.
Even though companies with high pricing power should be better prepared than their competitors to mitigate the impact of falling demand, it does not mean that possessing pricing power should be considered a survival mechanism in circumstances when demand for a product falls across the whole market or economy. It seems more appropriate to apply the term when demand is stable, but costs rise. In that case, the ability to adjust pricing and pass costs on to consumers might be considered a survival mechanism for a business that has the ability to protect its margins. But surviving on shrinking demand might require other qualities, not pricing power.
Sources of pricing power
The sources of the pricing power vary considerably among business types - a business-to-consumer company and business-to-business company have different sources of pricing power. While brand strength is a source of power for B2C companies, the quality of long-term relationships and communication with customers is a primary source for B2B companies. Understanding how customers perceive value and the ability to match and deliver that perception is key for B2B companies, while creating these said expectations and setting trends might be the key for B2C companies. Switching costs are also an important attribute of pricing power for B2B companies.
These are simply very different sources of power depending on the business. When we look for this power, it is always better to understand its source. Sustainability of pricing power means that a business should constantly improve the value it brings to customers in order to be able to exercise the pricing power when needed.
What determines pricing power?
Pricing power can be determined by the nature of an industry or be a company-level advantage. As such, we need to understand if these factors only apply to a specific industry or company. There are no direct determinants and easy answers to that question, but it is helpful to remember that:
- The structure of an industry greatly defines if a company can be a price setter or a price taker (larger barriers to entry would mean companies have higher pricing power).
- Greater product differentiation and personalization of product (or lower product substitutability) can lead to more inelastic demand curve for a company’s product, which affords it the flexibility to pass on costs to its customers.
What are the indicators of potentially high pricing power?
The best quantitative measures of pricing power are gross margin and margin stability over the business cycle. Companies that have pricing power can maintain their revenue and margins in hard times, meaning less deviation and higher forecastability of its returns, making a GuruFocus predictability score a useful measure to use in the analysis.
