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.
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 generate a lot of money for the company, since users have to buy roll after roll of film to take pictures and then spend even more getting the pictures developed. But new 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.
