How To Spot A Company With Pricing Power

People always talk about investing in companies with economic moats. One key feature of a company having an economic moat is one with pricing power. Here is a simple trick to find out if a company has pricing power at all.

Gross Margin

Gross margin is one of the most used financial ratios. It is a measure of how much profit a company earns as compared to its revenue. The formula for gross margin is:

(Gross Profit / Revenue) x 100%

A company with a gross margin of 50% would have its gross profit from the product being half of its revenue. It is a simple way to compare between companies in the same industry. If you have two companies which are competitors, we can compare their gross margins to see which company has a better margin from its product.

The company with a better margin tends to suggest that it has a better pricing power than its competitor. Apart from comparing gross margin between companies, we can also compare the gross margin of a company over time to see how it is changing over the years.

If the company can increase its gross margin over time, it might be a signal that the company can raise prices, which may also mean that it has pricing power. On the contrary, if we see a declining gross margin, it might be telling us that the company is facing some troubles with its economic moat.

Foolish Summary

There we have it; a simple financial ratio that can tell us a lot about a company. Just by seeing how a firm’s gross margin compares with its competitors or with itself over time, we can form an opinion on how strong the pricing power of a company is.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.