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."
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
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
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
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.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.