Pricing power: the most important business quality. Buffett gave the quality school its sharpest one-liner in 2011, speaking to the Financial Crisis Inquiry Commission:
"The single most important decision in evaluating a business is pricing power."
How do you test for pricing power?
His test is as plain as the claim. If you can raise prices and keep your customers, the business is a good one. If raising them by a tenth means holding a prayer session first, it isn't.
So filter 2 and economic goodwill converge on a test you already know from the moat module: does the business raise prices and keep its volume? Pricing power is the behavioural proof of a moat and what drives economic goodwill's nominal growth. See's raised prices nearly every year for decades. Nestlé India does the same on Maggi and Nescafé. Each price increase, on an almost fixed capital base, drops nearly straight through to owner earnings and swells economic goodwill. Now picture the airline holding a "prayer session" before a fare hike, the airline-brand contrast from the moat module. It has neither pricing power nor economic goodwill, and it isn't a Buffett-filter business. Those three failures are really one, seen three ways. For the rest of your life, whenever you evaluate a business, ask this quality question first. The numbers test, gross margin held through an input-cost cycle, is how you answer it without taking management's word.
Advertisement
What are look-through earnings?
Owner earnings tell you what one company yields to its owner. A concentrated owner needs the same figure across the whole book, and Buffett calls it look-through earnings: your proportional share of the earnings of every business you own, whether or not those earnings were paid out to you. Own 2% of a company earning ₹1,200 crore and your look-through earnings from it are 0.02 × 1,200 = ₹24 crore. A 30% payout sends you ₹7.2 crore in dividends and leaves ₹16.8 crore working inside the business on your behalf. Only the ₹7.2 crore shows up in your bank account. The point of the measure is that it refuses to treat the other ₹16.8 crore as nothing.
This has two consequences. First, the retained portion is only worth its face value if the business earns an adequate return on it. That's the same question economic goodwill asks, and the one-dollar test in the event-driven elective turns it into a decade-long scorecard: cumulative retained earnings against the change in market value, adjusted for issuance and buybacks. Second, a portfolio's look-through earnings, divided by what you paid for it, give you an owner-earnings yield for the whole book. A concentrated owner tracks that number instead of the quoted price. The portfolio-construction practice set computes it for a five-position portfolio.