How much would you pay?

This is Part-1 of a 2-part article on pricing and asset valuation. How much would you pay for a brand new product or a 4-bedroom house in New Delhi or a 40 seater Mexican restaurant? The key to figuring this out is to get your pricing/asset valuation right. Part 2 of this article deals with equity valuation.

Pricing is a whole branch of study in marketing. Take for instance a company like Hindustan Unilever Ltd. Say they are coming out with a new thin-film product which makes your mirrors fingerprint safe. Instead of having to clean the mirror every now and then to get rid of fingerprints, this new thin-film when applied to your mirror once will make it totally fingerprint-proof. You will never have to clean your mirrors ever again. How much would you pay for it? How much should the company charge you for it?

How much would you pay? – New Fingerprint Safe Thin Film for Mirrors (let’s call it Fingersafe)

There are multiple approaches to pricing consumer goods. The first one is the classic, standard, age-old, most popular technique called ‘cost-plus pricing’! As the name suggests, HUL would look into how much it costs to manufacture a single unit of Fingersafe (say Rs.10). They’d then add a % mark-up to it (say 30%) and determine the selling price (Rs.13). Of course, by the time it goes from HUL to the national distributor, down to the regional distributor, and finally, to the retailer, it might end up costing something like Rs.25. But you get the idea.

A second and relevant approach is to look at what the substitutes cost. Perhaps there is already an equivalent to Fingersafe in the market? And say it costs Rs.50. Then the pricing decision becomes one of should it be more or less than the competition? And by what exact %?

A third and more sophisticated approach is called ‘value-based pricing’. In this method, the folks at the marketing team try and figure out the true ‘value’ of a product like Fingersafe is to its customers. How do you figure that out? Well, think about it this way. Without Fingersafe, you’d have to buy some sort of mirror-cleaning solution at least once a year? Let’s say it costs Rs.5. And if the average lifetime of a mirror is 20 years, then over that time you’d have to spend Rs.100 (20 years * Rs.5/year) just to buy the cleaning solution. Add on to this, the cost of the time involved in cleaning the mirror every few months or so – that must be worth something too. They’ll do the math & perhaps decide that the actual value to the customers is Rs.150 and that’s what they will charge.

Do you see the huge range of pricing values (Rs.13 for cost plus, Rs.50 for substitutes based, and Rs.150 for value-based)? Rs.150 is the maximum that you will be willing to pay and they will want all of it.

How much would you pay? – 4-bedroom house in the centre on New Delhi

Residential real estate valuation/pricing is not well understood, especially in our country. Most people looking to buy a house rely on the price given to them by the seller. This advertised price becomes the benchmark around which most negotiations happen. Granted, homebuyers tend to look around to try and get a larger sample size of properties & prices. However, this way of pricing properties is still quite inferior.

Let’s go back to first principles. An investment in residential real estate offers returns in two parts. One, capital appreciation. And two, rental yield. If the mortgage on a housing loan costs about 6% per annum in interest rate, then the average year-on-year return on a property should be at least equal to that 6% if not more. So, when looking at pricing a property, one needs to evaluate what rental yield the property will offer and what capital appreciation potential the city/area could offer. This second bit can be harder to estimate, but it is possible to look at historic returns over the recent past and guesstimate what the figure will be in the future.

Let’s say that we are looking to buy this 4-bedroom house in the centre of New Delhi. Let’s say that the current rental on the property is Rs.25,000. Given that the New Delhi property market has got a massive oversupply problem, capital appreciation in the range of 3% per annum is the very best one can expect to make over the next 5 years. This means that the rental income of Rs.25,000 should represent 3% in rental yield to earn at least the 6% interest rate on the mortgage. So, the maximum property price you should be willing to pay is (Rs.25,000*12 months)/0.03 = Rs.1 Crore

There are even more sophisticated pricing models you can build. Think Replacement Cost. How much would it cost to buy a plot of land of the same size in the same area and build a similar house? Take that value, make downward adjustments for wear and tear and you have got yourself another price point for the same 4-bedroom property.

How much would you pay? – 40-seater Mexican restaurant

Say you are looking to buy this Mexican restaurant, which has 40 seats. It is open every day for 5 hours from 5 PM to 10 PM & is about 60% full most of the time. An average family of 4 people spend an hour at the restaurant and pay about Rs.2,000 per meal for the entire family. You think that at that price, the restaurant should earn at least 50% in profit. The restaurant owner wants you to cough up Rs.5 crores to buy the place. Do you reckon that’s a good deal??

The focus of valuing small businesses should be unit economics, which aims to simplify all the complexity associated with valuing businesses by measuring the profitability on a per-unit basis. Once this is determined, it should be a simple exercise of building it up.

Take the case of this Mexican restaurant. If the restaurant makes 50% profit on a table of 4 people paying Rs.2,000, they are in effect making Rs.250 per person. Their profit per day is 5 hours * 40 seats * 60% occupancy * Rs.250 profit/person = Rs.30,000 in profits per day. Annualising that to a year at 365 open days, total profit per year works out to Rs.1.09 Crores. At the asking price of Rs.5 crores, the restaurant owner wants you to sacrifice 5 years’ worth of profits. Do you think it is a good deal?

Now think about the same pricing question in another way. Say you go to the bank and get a loan of Rs.5 crores. The bank wants you to pay 10% interest on your loan per year – which is about Rs.50 Lakhs per year. If you used all of the money to buy this restaurant out, then at the end of year 1 you’d have paid the interest cost and have Rs.50 Lakhs in cash with you for the effort you put in. The loan amount of Rs.5 crores is still outstanding. Do you think it is a good deal?

Now think about the same pricing question in yet another way. You have Rs.5 crores in fixed deposits which is earning a rather poor 5% per annum at the moment (Rs.25 Lakhs per annum). If you took all of that money out and bought this restaurant out, your investment would have returned Rs.1 Crore in year 1 (or about 20% return on your investment) – about 4X the amount your FD was earning. Do you think it is a good deal?

Did you notice how the same pricing decision when viewed from multiple angles gives multiple perspectives?

How much would you pay? – A gear shaft auto-ancillary listed on BSE

Now how much would you pay for a stock listed in BSE which makes Rs.10 in EPS (earnings per share) each year growing at 10% per annum? Aficionados of the Price/Equity ratio will jump at the opportunity and perhaps say that a PE of 25 will be reasonable and price the stock at Rs.250. While this is a reasonable thesis to pricing stocks, it is extremely incomplete. Accrual based accounting earnings mask several important features of the business, all of which have to be taken into consideration while undertaking a valuation exercise.

To be continued…

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