Why investors should care about pricing power

How do you know if you should invest in a company or if it’s overpriced?

Pricing power—the ability to increase prices at least above cost, in real terms—is critical in determining a company’s value, said Marlena Zabielska, an associate portfolio manager with Sionna Investment Managers, at the firm’s spring market review.

The key to raising prices is product differentiation, Zabielska explained. For example, she asked, would you choose Heinz or no-name ketchup?

Zabielska said investors should consider three areas when gauging a business’s pricing power: qualitative factors, quantitative factors and sustainability.

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Qualitative factors include having a superior value proposition, a profitable customer and a habitual buying pattern, as well as controlling the market, Zabielska explained.

From a quantitative standpoint, the company should have stable or growing gross profit margins, expanding operating profits, and strong and increasing profit per customer or product.

Finally, investors should look at the company’s future sustainability and barriers to new market entrants, she added.

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Zabielska cited Whistler Blackcomb Ski Resort as an example. From a qualitative standpoint, “when we look at the regional competitors, we don’t think they stand a chance,” she said, noting other local resorts can compete only on price. Looking at the guests’ spending patterns, “quantitatively, we can confirm that the pricing power is there,” she added. In terms of sustainability, building a resort is difficult and capital-intensive—and “they’re not building mountains anymore,” she joked.

True pricing power is important because “when you increase your earnings power, you increase your returns,” Zabielska explained. It also indicates a competitive advantage, since companies can use it to offset certain macroeconomic factors.

But it’s not always easy for investors to tell the difference between a short-term blip and a long-term trend. “It’s important to distinguish true pricing power from temporary pricing power,” she noted. “A business that has true pricing power—that’s a gem.”