Starbucks' Seven Dollar Reminder

By Daniel Sparks - December 1, 2012 | Tickers: AAPL, COH, NKE, SBUX | 0 Comments

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In an interview with the Financial Crisis Inquiry Commission, Warren Buffett said that “The single most important decision in evaluating a business is pricing power." If any one coffee business has pricing power, it would have to be Starbucks ). Starbucks introduction of the $7.00 grande cup of Costa Rica Finca Palmilera coffee yesterday served as a stark reminder to its competitors and potential market entrants: Starbucks has pricing power.

Pushing the Limits

Would you pay $7.00 for the ultimate cup of coffee or $40 for an 8 oz. bag? Starbucks thinks so. The coffee is only available for a limited time in only a few locations but it will surely test the limits on Starbucks' pricing power. Starbucks isn't the first company to raise the bar with premium products at premium prices for their customers. Nike ) introduced the Lebron X with a $200 price tag. Pricing for Apple's ) 13" Macbook Pro with Retina Display begins at $1,700. Coach ) is notorious for its expensive handbags.

Pricing Power Matters

Premium pricing from brands like Starbucks, Apple, Nike, and Coach is often criticized as "taking advantage of consumers," but there is no question whether or not pricing power is lucrative for the business. 

Investors should always keep pricing power in mind when making investing decisions. Without pricing power it would be difficult for a company to sustain any durable competitive advantage. And without any durable competitive advantage it is nearly impossible to make any educated projection of a company's free cash flow. This in turn, makes it difficult to value a company and decide on its intrinsic value.

Identifying Pricing Power

How can pricing power be identified? One common approach is to look at gross profit margins. But directly comparing gross profit margins from one competitor to another doesn't always work since businesses typically are made up of very different business segments, even within the same industry.

So the first step in identifying pricing power is to understand the business segments and the geographical segments in which the company operates. Some business segments within the same company can be highly profitable while others could suffer from compressed margins.

The second step is to look for consistency in above average gross profit margins. If the company's business segments that possess pricing power represent a significant enough portion of the business' operations then you should be able to see a historical trend of solid gross profit margins. Let's see if this holds true for Starbucks, Nike, Apple, and Coach:

SBUX Gross Profit Margin Quarterly data by YCharts

Not only have gross profit margins for all four companies been steady (or even trending upward) for the past ten years, but they all fared well during the recession (highlighted in gray). Even as consumers pulled back on spending, these companies managed to maintain pricing power.

Pricing Power Pays

Pricing power happens to pay off quite well. The stock prices of all four companies soared past the S&P 500:

SBUX data by YCharts

The Bottom Line

Though it probably wasn't Starbucks intention when introducing the $7.00 cup of coffee, it serves as a reminder that some brands can charge premium prices and others can't. Pricing power is a highly reliable indicator of a durable competitive advantage. With historical evidence that businesses with pricing power outperform their peers and a blunt statement from the world's greatest investor calling pricing power the single most important factor in evaluating a business, I will always make pricing power a requirement for an investment to qualify for a position in my portfolio.

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