Getting To Know Business Models

By Ben McClure AAA

When analyzing companies, investors can easily get caught up in details such as performance figures, stock ratios and valuation tools while forgetting a more basic question: how does the company actually make money? A solid business model remains the bedrock of every successful investment. To distinguish the great companies from the losers, investors should learn how to describe and evaluate companies' business models. (Learn more about evaluating your own business model; read Is Your Business Model Viable? An 8-Point Test.)

TUTORIAL: Reading Financial Tables

What's a Business Model?
Quite simply, the business model is how the company makes money. It also explains the sources of the company's revenues, how much these sources pay and how often. So it's not enough to say that a company sells PCs or burgers. You need to go deeper and learn the structure through which the dollars are earned. Does the doughnut business include franchises or company-owned outlets? Does the burger company own the outlet real estate, as McDonald's does, or does it lease the space? Does the PC maker generate most of its money through direct sales, as Dell does, or does it sell via retailers, like Hewlett Packard does?

The business model also refers to how product delivery brings in revenue. Think about the shaving industry. Gillette is happy to sell its Mach III razor handle at cost, or even lower, because the company can go on to sell you the profitable razor refills, over and over. Their business model rests on giving away the handle and making profits from a steady stream of high-margin razor blade sales.

Electric shavers have a different model. They cost much more than the Gillette handle. Remington, a manufacturer of electric shavers, makes most of its money upfront, rather than from a stream of blade refill sales.

As industries change, companies can't always afford to stick to the same business model. Think about Kodak and the fast-changing camera business. Traditional film cameras generated a lot of money for the company, since users had to buy roll after roll of film to take pictures and then spend even more getting the pictures developed. But digital cameras do away with film sales and processing fees. So, in response, Kodak has had to create a new business model. The company has established digital printing centers, where users can have their digital camera pictures printed on genuine Kodak paper. The business model that was once based on film sales and processing has become a model based primarily on photograph printing.

A company's business model isn't always obvious. Consider General Motors. You might think GM makes its money selling cars and trucks. In fact, more than 60% of GM's earnings in 2003 came from finance payments, not auto sales.

Business models can also be downright counterintuitive. Conventional wisdom says that a retailer that crams stores close to one another will cannibalize own-store sales. But coffee retailer Starbucks has a business model that rests on just that: having coffee shops within blocks of each other. It turns out that market saturation drives up consumption, creates virtual wall-to-wall billboards for Starbucks, and cuts back on customer lines at more popular outlets. It also keeps competitors off the street. (For more on these businesses and how they work, check out Is Buying A Franchise Wise?)

Assessing the Business Model
So how do you know whether a business model is any good? That's a tricky question. Joan Magretta, former editor of the Harvard Business Review, highlights two critical tests for sizing up business models. When business models don't work, it's because they don't make sense and/or the numbers just don't add up to profits.

Because it includes companies that have suffered heavy losses and even bankruptcy, the airline industry is a good place to find business models that stopped making sense. For years, major carriers like American, Delta and Continental built their businesses around a "hub-and-spoke" system, in which all flights routed through a handful of big city airports. By ensuring that seats were filled, the business model produced big profits for airlines.

But the business model that was once a source of strength for the major carriers became a burden. It turned out that competitive carriers like Southwest and JetBlue could shuttle planes between smaller centers at a lower cost - in part because of lower labor costs, but also because they avoided some of the operational inefficiencies that occur in the hub-and-spoke structure. As competitive carriers drew away more customers, the old carriers were left to support their large, extended networks with fewer passengers - a condition made even worse when traffic began to fall in 2001. To fill seats, the airlines had to offer more and deeper discounts. No longer able to produce profits, the hub-and-spoke model no longer made sense.

For examples of business models that failed the numbers test, we can look at U.S. automakers. In 2003, to compete against foreign manufacturers, Ford, Chrysler and General Motors offered customers such deep discounts and interest-free financing that they effectively sold vehicles for less than it cost to make them. That dynamic squeezed all the profits out of Ford's U.S. operations and threatened to do the same for Chrysler and GM. To remain viable, the big automakers had to revamp their business models.

Conclusion
When evaluating a company as a possible investment, learn exactly how it makes its money. Then think about how attractive and profitable that business model is. Admittedly, the business model doesn't tell you everything about a company's prospects, but investors with a business model frame of mind can make better sense of the financial data and business information. It simplifies the job of identifying the companies that are the best investments. (For another way to evaluate a business, read Don't Forget To Read The Prospectus!)

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