Education: Aggressive Growth Investing

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Basics of a Business Model

The term “business model” was tossed around a lot during the internet bubble days, but what does it really mean? In the “Simpsons”, Lisa asked a fledgling internet CEO about his business model, and he replied, “How many shares of stock do you want to shut you up?” The tragic thing is that this was not far from the thinking that went on during that time. Any company received financing and saw their IPO’s explode as long as they had a Dot.com in their moniker. These are more rational times, and you need to be better prepared. Before crunching numbers on a company’s earnings and cash flows, make sure you know how it actually makes money.

Business Model Basics

The business model is a very basic concept. Essentially, it is how a company makes money. It also explains the sources of a firm's sales, how much these sources pay and how often. So it's not enough to say that a company sells cars or cell phones. You need to go deeper and learn the structure and mechanisms through which the revenues are earned.

Does the burger joint 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 answers to these questions reveal a lot in regards to the nature of the business and a firm’s profitability. Take one of the best growth stocks of the 1990’s: Dell Inc. It is no coincidence that the company had a revolutionary business model.

Dell: The Master Business Model

Dell Inc. was the trailblazer of the technology industry when it pioneered the direct sales model. This approach took out the middleman and sold directly to the customer. This in effect saved the company hundreds of millions of dollars in inventory management, which boosted its Return on Equity (ROE). Higher ROE usually means the market will award the company a higher price-earnings multiple.

Dell was able to customize each computer to a person’s particular tastes, rather than have its machines sit in a retail store becoming obsolete with every passing day. Customers were getting the best technology that was suited to their preferences, all at low costs to Dell.

Sheep in Wolf’s Clothing

The whole world knows that General Motors has been in trouble for several years. What is not well-known is that the company derived over 60% of its 2003 profits from financing rather than auto sales. For valuation purposes, this totally changed the multiple that was put on the company’s earnings since banking and automobiles are completely different entities.

This change in the composition of GM’s profits should have raised a red flag that perhaps the automobile industry’s business model was failing. In fact, Ford, Chrysler and General Motors offered such deep discounts and interest-free financing that they effectively sold vehicles for less than it cost to make them. That wrung out most of the profits out from Ford's U.S. operations and threatened to do the same for Chrysler and GM.

When looking at a new company, make sure and go much further than the usual metrics such as price-earnings, price-book, cash flows, debt, and EBITDA. The methods in which these metrics are created can tell you a lot more about the prospects of the business going forward.