Pick a thing. It can be anything: your car, an hour of your labour, your house. If you were to sell that thing how would you arrive at its price?

Option 1: Cost-plus pricing

If you were thinking of selling your house, this is likely the pricing model that jumped into your head first. You would probably recall what you originally paid to buy your house, then add some profit margin to that cost to arrive at a price at which you would be happy to sell. Many companies think this way too. Here is former Ferrari (RACE-NYSE) CEO Sergio Marchionne talking about pricing a few years ago:

We need to protect margins… It’s the only thing that allows us to continue to invest in the product that we’re launching. It’s the only thing. Nothing else matters.

Besides companies that make F1 cars, regulated power utilities often set electricity rates based on cost-plus pricing. However, in most other situations it is not the optimal way of arriving at a price. It is an inward-looking approach. It gives little consideration to what customers are actually willing or able to pay.

Option 2: Value-based pricing

For someone who works in sales, this is likely how his or her labour is compensated. In this situation it is quite easy to quantify the value the salesperson has generated for his or her employer. Thus, it is also quite easy to compensate that salesperson based on some percentage of the value generated.

Value-based pricing is even used in situations where quantifying the value is more difficult. For companies selling goods, the trick is to figure out how highly customers value your product and then charge them that amount. Starbucks (SBUX-NASDAQ) does an excellent job of this at the individual customer level. The company does not offer its seemingly-endless list of add-on customizations to avoid customer complaints about the coffee’s taste. Instead, SBUX offers these customizations so that they can extract the maximum-possible price from each individual customer. If you only want to spend $2.50 on a coffee, SBUX will sell you a coffee that costs $2.50. If a bigger spender behind you wants to spend $8.00 on a coffee, SBUX will sell them one of those too. And if the third guy in line wants to spend $54.75 on a coffee, SBUX will gladly pour them a cup and take their money:

Source: https://twitter.com/ACIFH/status/470365369127821312

The price charged for goods can even turn into a self-fulfilling prophecy about how much customers value it. This is how luxury goods are valued: prices are kept high to signal how highly valuable the products should be perceived on an emotional level (rather than a rational one). Both Canada Goose Holdings Inc. (GOOS-TSX) and Columbia Sportswear Company (COLM-NASDAQ) sell parkas. Yet GOOS generates 62% gross margins while COLM generates 50% gross margins largely because one benefits from luxury pricing while the other does not.

It’s important to note that value-based pricing refers to the value placed on the product by the buyer; not by the seller. That doesn’t stop a lot of sellers from doing it, though. The endowment effect is a behavioural bias that causes people to irrationally assign a higher price to an object when they own it versus when they don’t.

Option 3: Pricing in a competitive market

The most common method of pricing is driven by the supply/demand characteristics of the end market. Put informally, if there are more buyers than sellers, prices will be high and if there are more sellers than buyers, prices will be low.

Brick-and-mortar retailers used to have it pretty good. Year after year they could count on customers coming into their stores to shop, resulting in consistent profit margins that kept both management and shareholders happy. Then along came Amazon.com (AMZN-NASDAQ). Sure, Sears/Kmart/Zellers may have still wanted to price their products at a level that ensured a suitable profit margin, but if those same products were available from AMZN at a fraction of the price, then Sears/Kmart/Zellers was going to have to lower their prices to compete. Or as AMZN CEO Jeff Bezos more succinctly put it:

Your margin is my opportunity.

The result of Amazon competing on price? Here is how Sears Holdings’ (SHLDC-OTC) operating income as a percent of sales has evolved since the late 1980s:

Pricing of securities

These three pricing strategies come into play, at various times, in the investment world. The short-term variation of securities prices is a good representation of pricing in a competitive market. On any given day there are potential sellers and there are potential buyers. Whether or not they transact with each other depends upon whether they can agree on a price and volume at which they will transact.

In the present day, we believe that sellers have much more bargaining power in these transactions than buyers. The extraordinary monetary stimulus since the recession has resulted in a lot of cheap money flooding the markets in search of an attractive place to invest. This has increased demand for securities, meaning increased competition among buyers, resulting in prices going up steadily.

The financial crisis offered an example of when bargaining power swung the other way. As investors saw the economy collapsing around them, they wanted to exchange their volatile investments for the safety of cold, hard cash. This meant there was an increased supply of securities for sale on exchanges, which put downward pressure on their prices.

Whereas short-term traders are quite interested in how securities prices will change in response to supply/demand characteristics of the market, fundamental investors (such as ourselves) are more focused on value-based pricing. In our financial models we forecast a company’s future cash flow and then discount it back to the present day to arrive at a present value for a company’s equity. Thus, we have a solid idea about how much we value an individual security, and this value is independent of the current market price.

Not all investors separate their view of value from price, however. Just like the emotional impact that luxury goods pricing has, some investors want to buy shares simply because their price has already gone up. Whether this is caused by a fear of missing out (“FOMO”) or recency bias, we don’t believe it is a prudent way to value securities.

Finally, while cost-plus pricing may be a good way to sell cars, it’s a horrible way to sell securities. Known as the disposition effect, some investors are reluctant to sell assets that have declined in value, yet are eager to sell assets that have increased in value. The gist of this bias is understandable: it’s painful to partake in a transaction that guarantees losing money. But while some people may care if you’re sitting in a Ferrari, neither potential buyers nor competing sellers care if you’re sitting on a losing position.