Lesson 5 of 7
Pricing power, and how to see it
Pricing power leaves traces in a filing, a margin that holds through cost inflation, named price rises with no lost volume, revenue per unit outrunning cost.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Pricing power means a company can raise prices to cover rising costs without losing enough volume to matter.
- The clearest trace of it is a gross margin that holds, or a price rise named in MD&A with revenue still growing.
- Without it, the same cost inflation falls straight through to margin.
Pricing power is not a claim you take from a company's own description of itself. It is what a filing shows happened the last time its costs rose: did the margin hold, or did it fall.
Gross margin through a year of rising input costs
- Held prices up with costs
- Could not raise prices
Show the numbers
| Held prices up with costs | Could not raise prices | |
|---|---|---|
| Before the cost rise | 40% | 40% |
| After the cost rise | 40% | 28% |
The three traces to look for
A gross margin that holds. Input costs rose across the industry and this company's margin did not fall with everyone else's.
A price rise named in MD&A, with volume not falling. Item 7 often states that prices were raised; check the revenue and unit volume lines for whether customers kept buying anyway.
Revenue per unit outrunning cost per unit. Over several years, a company with pricing power raises what it charges faster than what it pays, even without a single dramatic price increase.
Buffett's three conditions
Berkshire Hathaway's 1991 shareholder letter describes an economic franchise as a business selling something customers need or want. Customers must believe it has no close substitute, and it must not be subject to price regulation. All three matter together: a product customers want but can easily substitute, or one that regulators price, does not clear the test even if demand is strong. The letter says all three show up as the ability to raise prices regularly and earn high returns on capital.
What blocks it
A commodity product, one buyers can switch away from at no cost, has no pricing power almost by definition. Greenwald and Kahn's Competition Demystified traces lasting pricing power to barriers to entry, customer captivity, such as habit or switching costs, and economies of scale a smaller rival cannot match. Where none of these is present, a cost rise simply falls through to margin.
Check yourself
A company's input costs rise 20 percent and its gross margin does not change. What does that suggest?
- Its costs did not really rise
- It was able to raise its own prices to match
- Its accounting is wrong
Show the answer
Answer: B.
A steady margin through a cost shock is the clearest sign a company passed the higher cost on to its customers rather than absorbing it.Under Buffett's 1991 conditions for an economic franchise, which of these fails it even with strong demand?
- A product customers need, with no close substitute, priced freely
- A product with strong demand but subject to price regulation
- A product with a loyal customer base and no substitute
Show the answer
Answer: B.
All three conditions must hold together. Price regulation caps what a company can charge no matter how strong demand is.Which of these is the weakest evidence of pricing power on its own?
- A gross margin that held through an industry-wide cost rise
- Revenue per unit outrunning cost per unit over several years
- Management describing the product as premium in an earnings call
Show the answer
Answer: C.
A description of the product is not a filed number. Pricing power is judged from what the margin and the revenue lines actually did.Sources
- Berkshire Hathaway shareholder letter, 1991, on the economic franchise: needed or desired, no close substitute, not subject to price regulation.
- Greenwald and Kahn, Competition Demystified, 2005, on barriers to entry, customer captivity and economies of scale.
What this leaves out
- The margin chart and the cost-shock table are illustrative, built on round invented numbers, and name no company.
- A held margin during one cost cycle is evidence, not proof, that pricing power will hold through the next one.
- Cutting costs can also protect a margin; the margin alone does not say which happened.
- A pass-through contract, a hedge or inventory timing can hold a margin with no pricing power; read MD&A for which it was.
- Nothing here is advice about any security.