Price Elasticity and Its Effect on the Value of Companies
The concept of elasticity is an important concept when talking about economics, and thinking about the ways in which markets behave. Investors should also consider price elasticity as an important way to measure the value of a brand, and as a way to compare major competitors, especially in moderately competitive sectors.
Elasticity is the measure of how a change in the price of a product will change the demand for that product:
When considering the elasticity for various products, it is important to categorize them such that you are comparing apples to apples. For instance, a product like gasoline is likely to have a lower price elasticity because it is an essential good — in comparison, apples may have a higher price elasticity because as a consumer, I don’t need to purchase an apple; there are many substitute goods on the market, that can replace the apple, like bananas, or oranges.
Another interesting phenomenon with elasticity is that typically expensive goods are more elastic than cheaper goods because as consumers, we are more conscious of purchases that make up greater portions of income. When firms (by absolute value) have lower price elasticity of demand, it illustrates that consumers are not driven by price, but instead are focused on obtaining the product, as they see it to be very valuable, or irreplaceable. In comparison, firms with higher price elasticity of demand have less room to adjust prices and face greater pressure to continue producing at a certain price.
A really interesting application of elasticity is Apple’s iPhone. At first glance, investors may be impressed or unimpressed by some of Apple’s financials. For instance, Apple’s Enterprise Value/EBITDA is 16.29, which is relatively high, and basic ratios like P/BV and P/E raise questions about the stock’s value. However, among other things, brand value is one of the things that makes Apple such an attractive company to consumers, and thus investors. For many, personal experience and observations is an effective tool to get a sense of how valuable a company’s brand is, but elasticity is a simple way to get a sense of how loyal and dependent a customer base a company has built. For instance, with Apple’s iPhone, elasticity is estimated as follows:
What this signifies is that for the iPhone 4, every 10% increase in price results in a decrease in demand of only 1.08%. In part this illustrates that Apple has a customer base that depends on Apple products, and is not overly concerned with change in price. Sure enough, as the Apple brand progresses and prices disproportionately skyrocket in comparison to the added value brought by each new model, Apple continues to boast solid sales of the iPhone.
The other important concept relating to elasticity is cross price elasticity, which measures how the change in the price of one product translates to a change in the demand of another:
Typically, when two products are substitutes, the Cross Price Elasticity of Demand will be positive if two goods are substitutes, and negative if they are compliments. When using this to evaluate a company, a higher cross-price elasticity of two substitute goods illustrates that a company has little control over its price, and is heavily dependent on competitor’s prices. For instance, gas stations would have a very high cross price elasticity of demand, which means that if one station can lower its prices, the other is practically forced to follow suit. In comparison, one of Apple’s greatest assets is that its prices are largely independent to those of Samsung:
Interestingly enough, the cross price elasticity between iPhones and Samsung is only 0.004, showing they are very weak substitutes. This shows that although they produce similar goods, Apple and Samsung consumers do not particularly view one as a competitor to another, and that each company has a loyal following. Moreover, Apple has the power to control the demand for its different products, since cross price elasticity among iPhones is considerably higher, and thus apple can shift demand from one iPhone to another relatively easily. Both these factors add value for Apple because they demonstrate that Apple operates in a more monopolistic market than it would appear at face value. This allows Apple to charge high prices for their products, and continue to increase revenue amongst the same clientele.
Overall, elasticity and cross-price elasticity of demand are two concepts that demonstrate the brand value of companies. Although they are far from the first place to look when evaluating a company, they provide some numerical context to the valuation of brands in different industries! The next time you are buying a phone, ask yourself how much the price plays into your choice. If you are an Apple loyalist, it is likely that price only dictates which iPhone you purchase, not whether you buy an iPhone at all! Investors should keep this in mind when valuing Apple as a company.
