By reading about many investors I have realized that looking at an investment case from different angles and perspectives unearth insights which can be very valuable. For example, in a simple DCF framework we value a company only based on its long term cash flows. However, the assets of the company could be used for something totally different and unrelated which can create more value.
There was a story I read about a chain restaurant which was struggling only to be eventually taken over by a smart guy. He sold some of the locations and rented out some other as office space etc. The assets therefore were acquired by the guy who could bring out the maximum value in them. I came across an article in the blog Basehitinvesting which to me was a very interesting way of looking at a company. Instead of trying to find undervalued companies we could try to identify undervalued products and back calculate to see if the company looks undervalued if pricing of the product is maximized.
The blog piece referred to Warren Buffett’s purchase of See’s Candy. Generally we buy companies when we feel that market has underestimated its value (market price lower than intrinsic value). However, Buffett mentioned that he felt See’s Candy had a product which was undervalued. I believe he possibly meant that the product has price inelastic characteristics which allowed the company to increase prices without affecting demand substantially. If a company is trading on a P/E multiple of 20x but has the ability to increase price by lets say 25% then it might not be as expensive as it looks.
I am sure Buffett did not make his purchase decision only based on the mathematics but it surely played a role in him purchasing the company on headline multiples that appeared (not in hindsight) quite expensive.
Not all revenue growth is the same
The advantage of a product with an undervalued product needs to be understood in some more detail from a mathematical sense. Analysts usually do not differentiate between revenue growth coming from price hike and those coming from volume. In most companies volume is the biggest driver of revenue (prices typically increase in line with costs). Incremental volume increases revenues but also increases variable costs (and fixed costs from time to time also). Price growth on the other hand is not accompanied by increases in any costs. Therefore, a 25% price growth may lead to a 50-100% increase in profits (depending on the margins).
A word of caution is warranted here. Products with true pricing power are exceptionally rare. Those which are very habit forming like cigarettes tend to have them but most products have a limit after which they to become much more price elastic. Additionally, if a company has an undervalued product rationally they would have increased the price already to maximize their profits.