Why Pricing Power Is So Important
Inflation is back. The latest reading on the Consumer Price Index showed a 1.2% increase just for the month of March, more than the CPI had gone up in some entire years recently and the biggest monthly increase since 2005. Compared to 12 months ago, the CPI was up 8.5% — the biggest year-over-year jump since 1981. We’ve all seen the impact at the pump, at the grocery store, and in the bills we pay.
For many companies, the news has been even worse. The Producer Price Index measures the costs that businesses have to pay their suppliers for goods and services they need in order to serve their customers. The PPI jumped 1.4% in March, bringing its 12-month total rise to 11.2% — its biggest jump on record since the index’s start in 2010. Costs of many intermediate goods have risen 20% to 40% over the past year.
Does Inflation Hurt Everyone?
It’s easy to understand why inflation is bad for nearly every consumer. When you make a fixed salary or hourly rate, having to pay more for what you need leaves you with less money to spend on what you want. Some people are left without enough even to cover their needs.
For businesses, the impact of inflation gets more complicated. That’s because most companies have to buy goods or obtain services from suppliers and then turn around and sell them to consumers. Depending on how much pricing power they have, businesses could end up taking a hit even if they end up charging their customers more.
What Pricing Power Really Means
Say a business has historically paid suppliers $100 for products that it then resells at a retail price of $200. Due to inflation, the suppliers boost their prices by 10% to $110. Depending on its pricing power, there are three possible outcomes:
- If the business has no pricing power, it can’t change its $200 retail price. Its profit falls from $100 per unit to $90. The stock price of businesses in this situation typically gets punished during periods of high inflation because of their prospects for lower earnings.
- If the business has enough pricing power to pass through its higher costs to consumers, it will boost its retail price to $210. That will leave it with the same $100 per-unit profit, with no impact on earnings. Consumers will see a 5% increase in what they pay, which is less than the 10% increase in the producer cost. Stocks of businesses in this situation typically do better than those without pricing power.
- Some elite businesses have so much pricing power that they can pass the entire percentage increase through in their costs to consumers. In this case, a 10% increase in the retail price would make it $220. Profit would rise to $110 per unit, with a potentially sizable overall earnings increase to help bolster the stock price.
Be Prepared for Anything
Pricing power is valuable even when overall inflation is low. It’s also the result of strong operational success and brand-building, which comes with other benefits as well.
Companies with pricing power would hold up better if inflation reared up at some point in the future. Investing well requires being ready for whatever may come. Great companies are better prepared than their peers, and that’s why we seek them out for our recommendations whenever we can find them.
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