Originally posted on October 1st, 2015
The recent economic downturn has made even more critical for investors to identify companies with durable competitive advantage and more specifically what is known as pricing power. But why (and how) do some companies outperform their direct competitors in this matter?
With my colleague Vinay Kanetkar from Guelph University, a large dataset of 260 firms among the Fortune 500 across 11 years has been collected, showing the following pattern: if a firm raises its price by 1% percent, then the average firm’s profitability would go down by about 5.64%, which is counterintuitive for most pricing professionals.
One of the key learnings of our research, is that these results vary greatly between and within sectors. Therefore, our research also provides a very useful benchmark on how companies behave regarding pricing power.
For each industrial sector (118 in total, the more granular sector cut in COMPUSTAT), we computed each company’s pricing power performance within its own industry.
Applying systematically the industry approach to the dataset, we extracted 55 companies with superior Pricing Power following a mathematical derivation from their financial statements allowing us to differentiate two distinct traits of Pricing Power: a lower price sensitivity (explained by a higher willingness to pay for its products) and a higher capacity to extract value from the market (i.e. positive price profit elasticity). We then constructed an Index of Market Capitalization of these firms (Pricing Power Index) and compared it with the S&P 500 Index as displayed in the introduction dashboard.
Understanding impact of Pricing Power, and more broadly the impact of value creation on profit, is crucial for managers. The approach followed in this research offers a new perspective on the trade-offs between value creation and capture of premium at the corporate level. Pricing Power – as we compute it (i.e. at the corporate level)-, offers an interesting insight on differences among companies on their ability to transform brand equity (for example) into a sustainable revenue Premium.