Undervalued stock vs undervalued product

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.

Pricing power

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.

Asif Khan, CFA

Asif Khan is presently a Research Analyst (Financial Sector) for Exotix which is a frontier market focused investment bank. He has more than 6 years of work experience as equity analyst in both buy and sell side roles across Asian frontier markets. Asif is a CFA Charterholder and has a dual major in Finance & Economics from North South University.

2 thoughts on “Undervalued stock vs undervalued product

  1. As an analyst, how can we assume that a company is charging below the highest possible price it can charge for driving the target sales volume?

    1. It is easier said than done. I mean even in hindsight I am actually not clear how Buffett realized that See’s Candy products were undervalued. I think one way to realize is when a company has a product of superior quality compared to competitors at prices equal or even lower. Unlike the example provided, instead of a 25% price hike in one go we are more likely to see the prices going up over a period of time to get users used to higher prices. The typical example will be cigarette. We have almost gotten used to the fact that premium cigarette prices will be going up by 1 taka every year.

      Other than this products with strong pricing power are those which have strong brand loyalty (i.e. Coke), habit forming (i.e. cigarettes), sometimes used as a small component of a big product (a small parts in a car is fraction of the value), has entry barriers in the industry etc (patents in Pharmaceuticals).

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