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2012-01-03 12:46:05
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!)
by Ben McClure
Ben McClure is a long-time contributor to Investopedia.com.