If you had to put 100% of your money into a company, and you could only ask one question about it, what would you ask? The best question might be this: How much pricing power does the company command?
It's a very simple equation. If a business can sell goods or services for more than it must pay to provide or produce them, it makes a profit. However, pricing power comes in many different shapes and forms, so let's take a look at some key questions to ask.
Does the company sell commoditized goods?
In industries where goods aren't distinguished by quality, it's best to go with the low-cost producer, because customers only care about price. As Rosie Blumkin, who founded the famed Nebraska Furniture Mart, puts it, "If you have the lowest price, customers will find you at the bottom of a river."
Inside Value pick Wal-Mart (NYSE: WMT ) grew into a $250 billion company by continually lowering the bar on pricing. Many suppliers hate dealing with this retail juggernaut, because they constantly get squeezed on pricing. But the customers seem to love it. Over time, customers will find the lowest prices, and low-cost producers will take market share from less efficient competitors.
Is the product substitutable?
The uniqueness of a product directly correlates with its pricing power. If I'm the only plumber in town, then I could name my price to fix your clogged toilet. If I'm one of 20 plumbers, there are 19 other options for any customer who doesn't like my price.
If you live in southern California, you'll notice that even though there are plenty of theme parks around, Stock Advisor recommendation Disney (NYSE: DIS ) charges a whopping $63 for a single adult ticket, versus $49 for a ticket to Knott's Berry Farm. Why? Because if you're the only theme park around with Mickey Mouse, and your kids want to see Mickey Mouse (most kids do), you can charge a very high price for Mickey Mouse access.
What's the industry structure like?
The number of competitors relates inversely to the profits each participant earns. Although we don't think of carpet as a high-margin good, the industry's consolidation down to two major players, Mohawk (NYSE: MHK ) and Shaw, which is a unit of Berkshire Hathaway (NYSE: BRK-A ) , means that both companies can earn very healthy operating margins and returns on capital.
On the other hand, there are simply too many airlines. As a result, the industry remains too fragmented, and it continues to suffer from overcapacity. Although it enjoys a few profitable years every now and then, in the long run, airlines as a whole continue to bleed red ink.
How important is the product to the customer?
Some companies sell products customers can't live without. For example, Altria's (NYSE: MO ) Philip Morris brand has many customers who basically can't go a day without its cigarettes. Thus, Philip Morris doesn't sweat too much if it has to raise prices.
Does the product have a strong brand name?
Do customers order the product by name? When people go to restaurants, they order a Coke. When they need information on the internet, they Google it. When they go to grocery store, they'll pay almost twice as much for Cheerios as the nearly identical generic brand. As human beings, we identify and become extremely attached to brands, bestowing substantial pricing power upon the brand-owner.
That's hardly an exhaustive list of intelligent questions to ask when trying to gauge a company's pricing power, but by now, you should understand the concept. Remember: The companies with the strongest, most durable pricing advantages should reward shareholders the most.