Understanding a company's business model

In simple terms

A business model is how a company turns what it does into money. Before looking at any ratio, an analyst should be able to answer four questions in plain language:

1. What does the company sell? Products, services, or access to something.
2. Who pays for it? Consumers, other businesses, governments, advertisers.
3. How does it reach them? Its own shops, dealers, distributors, online, a sales force.
4. What does it cost to provide? Raw materials, people, factories, technology, marketing.

If you can answer those four clearly, the numbers in the financial statements start to make sense. If you cannot, the numbers are just numbers.

The user is not always the customer

Many people assume they understand a company because they use its products. Often the person using a product is not the one paying for it.

• A free video platform is used by viewers but paid for by advertisers.
• A medicine is taken by a patient but may be paid for by an insurer, a hospital or the government.
• A school's textbooks are read by students but chosen and bought by schools.

The paying customer decides what the company must do to grow. A business whose users love it but whose paying customers are cutting budgets is in a weaker position than it looks from the outside.

Where revenue comes from

Most companies have more than one source of revenue. List them, and ask which ones matter most.

Recurring and one-off revenue

Recurring revenue is earned again and again from the same customers: subscriptions, maintenance contracts, consumables that must be replaced, fees on money managed. One-off revenue comes from a single sale that may or may not be repeated: a car, a flat, a large project.

Recurring revenue is usually more predictable, because most of next year's customers are already this year's customers. Investors therefore often value a rupee of recurring revenue more highly than a rupee of one-off revenue. But recurring revenue is only as durable as customers' willingness to keep paying; contracts end and subscribers cancel.

Some businesses sit in between. A company selling printers cheaply and ink expensively turns a one-off sale into a stream of repeat purchases.

Customers, suppliers and distribution

Three more questions sharpen the picture.

• How concentrated are the customers? A company that sells half its output to one buyer depends heavily on that buyer's decisions and can be pushed on price.
• How dependent is it on suppliers? A single source for a key input is a risk; many alternative suppliers give the company bargaining power.
• How does it reach customers? Owning the route to the customer, such as a large dealer network or a strong online presence, can be hard for competitors to copy. Depending on a few distributors can be a weakness.

Where to find the answers

The annual report is the main source. The directors' report and management discussion and analysis describe the business, its markets and its strategy, as the MD&A lesson explains. The segment note in the notes to accounts splits revenue, profit and assets by business line or geography. Investor presentations and conference call transcripts, filed with the exchanges, often explain the model in more detail.

Read management's description critically: it is written by people who want you to think well of the business.

A one-paragraph summary

A good test of understanding is to write the business model in a short paragraph that someone with no finance background could follow. For Kaveri Appliances:

Kaveri makes washing machines and refrigerators in two factories and sells them through about 3,000 independent dealers. Households pay once for a machine, which they replace every eight to ten years. Kaveri also earns steady fees from maintenance contracts and spare parts on machines already in use. Its main costs are steel, plastics, compressors and advertising.

Everything later in fundamental analysis, growth, margins, returns and valuation, builds on a paragraph like this.

Why it matters

The business model tells you what drives the numbers, and therefore what to watch. For Kaveri, household spending and steel prices matter; for a subscription business, renewal rates matter. It also tells you what could go wrong: a change in who pays, a key customer leaving, a new route to customers that competitors control. Valuations built without this understanding rest on extrapolating past numbers, which is exactly when they fail.

Limitations

A business model describes how a company works today. It does not tell you whether the company will keep its customers or earn good returns; that depends on its industry and its competitive position, covered in the next lessons. Companies' own descriptions can also be incomplete or optimistic, and segment reporting groups activities in ways that suit management.

Common mistakes

• Confusing familiarity with understanding. Liking a product says little about the business's economics.
• Ignoring who actually pays. The paying customer decides the company's fortunes.
• Treating all revenue as equal. Recurring and one-off revenue behave very differently in a downturn.
• Skipping the segment note. A small, fast-growing segment can hide a large, shrinking one.

Try it yourself

Pick a listed company whose products you know.

1. Find its latest annual report on the NSE or BSE website.
2. Using the MD&A and the segment note, list its revenue sources and the share of revenue each provides.
3. Mark each source as recurring, one-off or in between.
4. Write the business model in five plain sentences covering what is sold, who pays, how it is sold and the main costs.