The single most important decision in evaluating a business is pricing power. 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%, then you've got a terrible business.
Warren Buffett understands a thing or two about successful investing, and he says pricing power is the most important factor to consider when making investment decisions. Let's look at why this is such a crucial aspect to keep in mind, analyzing examples from Apple (NASDAQ:AAPL) and Chipotle Mexican Grill (NYSE:CMG), two companies delivering extraordinary performance for investors while flexing their pricing muscle.
The importance of pricing power
Pricing power is a company's ability to raise prices without losing too much sales volume because of this increase. This factor has some clear advantages from a financial point of view, as higher prices usually mean bigger profit margins for the company and higher returns for investors in the long term.
Also, pricing power says a lot about a company's competitive strengths. Competition tends to keep prices at bay. If a company raises prices too much, consumers will typically go for a competitor's cheaper product. Businesses with superior pricing power are those with competitive differentiation, meaning that consumers find something unique or superior about that company and its products.
To have pricing power, you need competitive strength. This can come from a higher-quality product, a differentiated brand, or technological superiority, among other possibilities. In addition to generating higher profitability, competitive strengths protect the business from the competition, and this substantially reduces the risks for investors.
Most electronics manufacturers need to aggressively compete on price to sustain market share. Apple, on the other hand, benefits from tremendous brand power. Both Interband and the Forbes Brand Ranking consider Apple the most valuable brand in the world, and this is a huge advantage for the company and its shareholders.
In times of competitively low smartphone prices, Apple reported a sequential increase of $42 in the average selling price for the iPhone segment during the quarter ended in September. The new iPhone 6 and iPhone 6 Plus models are selling remarkably well in spite of higher average prices. Sell-through unit growth was an impressive 26% during the quarter.
Even better, sales are booming in emerging markets, where income levels are lower and the carrier subsidy model is not as extended as in the United States. This performance shows that Apple is firing on all cylinders, even in markets where selling products for higher prices than the competition should theoretically be a significant drag on volume growth.
While iPhone unit sales increased 17% year over year in the U.S, sales in Western Europe were up 20%. Growth was even stronger in Latin America and the Middle East, with sales increasing more than 50%. In Central and Eastern Europe, iPhone unit sales more than doubled during the last quarter.
This ability to combine explosive volume growth and rising prices bodes extraordinarily well for to Apple and its ability to sustain growing revenues and cash flows into the future.
Chipotle Mexican Grill
The restaurant industry is savagely competitive, especially in the fast-food and fast-casual segment. That's not stopping Chipotle Mexican Grill from raising its prices and still delivering mind-blowing sales growth.
The company implemented an effective 6.3% price increase during the September quarter, and the average check was up by 8.5%, according to management. But comparable-store sales still increased by an explosive 19.8% during the period.
CFO John Hartung said in the last conference call:
Although our menu prices increased, we continue to see very strong transaction growth and we are experiencing very little price resistance, just under 1% so far with very little menu trade down. We are delighted to see that the price increase we had to take after three years of absorbing food inflation had little or no effect on the strong customer loyalty we have worked so hard to build.
Chipotle's business model is based on offering higher-quality food, fresher ingredients, and a more efficient service than the competition. That means higher costs for the company, but customers seem more than happy to pay a few extra bucks when it comes to Chipotle. Clients see Chipotle as essentially different from other restaurant chains, and that's a major plus for investors in the company.