For years, the pricing industry has focused on the profit leverage of improving pricing by 1%, from the famous McKinsey article many years ago, which revealed that for the average company a 1% increase in price would translate to an 11% increase in profits. And that seems to have become the default priority of most pricing solutions?
But if your goal is to increase the value of your company, which will have a bigger impact? A 1% increase in price or a 1% increase in growth rate? The answer may surprise you, and more importantly, it may change how you think about your own pricing strategies. And it should! Because for most companies a 1% increase in price will not have near the impact to company value as a 1% increase in growth rate.
As an example, let’s take a hypothetical company that does $400 million in revenues and $48 million in profits, both of which have been growing by approximately 5% per year for the last few years. For simplicity, we’ll assume their churn rate is zero. They are currently valued at 12.5X profits, which implies a present value discount rate of 13%.
Using a specialized “Company Value Calculator,” we see that the value of the company is calculated at $600 million, as shown below:
The four numbers in the yellow boxes of the company value calculator are called “The Five Sacred Metrics of Pricing Success” because they are all affected by pricing strategies and the combine to calculate the value of the company. These types of tools are very useful, because they show how key pricing metrics flow into the value of the company.
Now let’s look at how a change to a few of these metrics affects the value of the company. For this we will use a version of this calculator that allows for scenario calculations.
If we increase prices by 1% (and assume we lose no customers or sales) then we see that profits increase by 8.3%, and that translates to an 8.3% increase in company value. The value of the company grows from $600 million to $650 million, an increase in $50 million dollars, which is great. But now let’s plug in an increased growth rate from 5% annual growth to 6% annual growth. What will this do to the value of the company?
If we merely increase the growth rate from 5% to 6% per year, the value of the company goes up by 14.29%, or $85.7 million dollars. Almost double the impact of a 1% price increase.
Why did this happen? The reason is simply this. The value of the company is based on the present value of all future cash flows or profits. When you increase the growth rate, it exponentially changes the value of all future profits because it compounds on itself. If you look at just one year, that additional 1% is worth only $4 million in revenues and only $480K of profits, but because that extra revenue and profit amount goes on compounding every single year, then it’s worth $85 million in company value.
That’s the piece that most people miss. Most short-term focused executives would rather have the $4 million in extra profits vs. the $480K of extra profits the comes with the bigger growth rate. But that’s not how to maximize the growth of a company. Amazon did not become the world’s most valuable company by raising prices. They did it by raising growth rates.
If you want your pricing strategies to maximize the value of your company, you need to be looking at the metrics that contribute to the calculation of the value of your company.
The beauty of increased growth rates vs. price increases is that growth rates typically do not change the risk profile of revenues, whereas raising prices almost always adds risk of increased churn, which can negatively impact growth rates. For this reason, increasing growth rates is a more sustainable source of continuous profit growth than raising prices, which can be done only once or twice before it becomes much too risky to continue raising prices into the future. And there’s nothing that says your growth rates need to be limited to increases of 1%. While pricing increases of 5-10% would be seen as highly risky for most businesses, increasing growth rates by 5-10% happens all the time. And just for grins, if you plug in a growth rate increase of 5% (instead of 1%), you get a massive increase in company value, as shown in the scenario calculator below:
All of a sudden, we are talking about increasing the value of the company by $1 billion, an increase of 166.7%. This happens because of the compounding nature of higher growth.
It’s not unreasonable to believe that you double the value of your company in just 1-2 years, just by focusing in on the highest impact pricing strategy opportunities. This is a much different story than pursuing that elusive 1% price increase to grow profits by 11%.
Pricing has the power to massively grow the value of the company, as long as they have the right metrics and the empowerment to make important changes to the company’s growth strategy.