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An error we come across quite often is people not appreciating the business model of the company in which stock they're investing in. We would argue that a full understanding of a company's business model is as important as having a firm understanding of its finances. Much of the earnings potential depend crucially on the business model. Let's just give a few examples to make this clear.

Software
Software offers many opportunities for a profitable business model. It is a high fixed-cost, low marginal cost business, that is, once the software is developed and having achieved a certain scale, 'non-linearities' will kick in. The non-linearity here is that profits increase disproportionally with sales after a certain threshold, because the marginal cost are so low (unless the company has to spend a lot on research and development to keep the software up to date and competitive, that will significantly blunt these 'non-linearities').

Due to network effects, learning effects, or other externalities, software also offers unique opportunities to establish standards. Windows became a standard because it's easier to have a dominant operating system for PC's for which all applications can be written and in which users can invest a good deal of time to learn to navigate it.

Which software becomes a standard is often a matter of chance, rather than quality. Small first-mover advantages can easily develop into unassailable positions, even outside the realm of software. A famous case was how the video standard VHS (from JVC company) won over the better betamax from Sony (NYSE:SNE) and V2000 from Philips (NYSE:PHG). There are different reasons given for this (recording time, price, access to 'adult' material, etc.) but they all seem rather trivial and what's not debatable is that the latter two standards provided better picture quality.

Once a standard is established, high switching cost can basically keep it in place for a long time, even in the face of the emergence of superior standards. In fact, so difficult can it become to unseat the reigning standard that the main competition could come from open standards or efforts to create 'interoperability' (that is, create applications that run on more than one platform). This is what happened with Microsoft's (OTCQB:MFST) Windows.

So the low marginal cost, de-facto market standard, and high switching cost made Windows an extremely profitable product. But this is by no means guaranteed for all, or even most software.

Weaknesses
However, software based business models also often have weaknesses. Entry barriers are often low, and functionality might be simple. This is one of our gripes with the 'social media for business' hype, which is also plagued by lack of standard and low network effects (and hence little need for a standard).

The social media software platforms for business from the likes of Microsoft (NASDAQ:MSFT), Salesforce.com (NYSE:CRM), IBM (NYSE:IBM), Google (NASDAQ:GOOG), EMC (NYSE:EMC), Cisco (NASDAQ:CSCO), HP (NYSE:HPQ), Jive (NASDAQ:JIVE), Yammer, Lithium, IdeaPlane and a host of other, smaller companies like Broadvision (NASDAQ:BVSN) are all relatively simple fare.

Well, so is Facebook, you would say. Yes, but in the consumer space, having a standard makes more sense, and Facebook just happened to have first-mover advantage that developed into the de-facto standard.

The social network platform for business are more tools for the company's employees, even if it can be extended to suppliers and customers. But it doesn't matter all that much that company A uses a different platform than company B, so having no dominant standard isn't a big problem here.

Also, Facebook is commerciably exploitable, making it much more valuable as a platform, as it can be exploited by many different parties (for a fee). Social network platforms for business are first and foremost a tool for its employees, even if the company itself can exploit it (or they could develop into buyers or sellers market platforms, or marketing tools).

Investors need to understand these dimensions of the business model, as the earnings power crucially depend on it.

Solar energy
Another good example where the business model matters a great deal is solar energy. Solar cell producers like First Solar (NASDAQ:FSLR), Suntech (NYSE:STP), Trina Solar (NYSE:TSL), Jinko Solar (NYSE:JKS), LDK Solar (NYSE:LDK), and Yingli Solar (NYSE:YGE) are basically producing a commodity. Investors easily get starry eyed by the fantastic growth potential of the industry, growing at some 40% a year and nearing grid parity in many places.

The latter is important as that enables solar energy to survive without government subsidies, which are being reduced in many places like Germany, the biggest market for solar cells in the world. However, there are still a few important parameters here:

  • Some companies (like First Solar in the thin film sector and Trina in the crystalline silicon sector) are cost leaders (even if First Solar is under pressure from the crystalline based producers), they have more efficient production processes than others
  • There are modest economies of scale and learning operative. That is, bigger companies with more experience tend to have a mild cost advantage
  • There are some returns to branding. That is, companies like Suntech have a reputation for using first rate materials which enable them to command slight premium pricing
  • Big established players enjoy another advantage besides scale and learning economies. They are thought of as longer lasting, able to survive the (present) severe price erosion, which gives them an advantage ('bankability')
  • There is some product improvement with producers embarking on different routes to use less material and improve the efficiency of their solar cells.

However, the big wildcard in the industry is outside innovation by new start-ups (or university labs), taking whole new approaches and materials. These developments have the potential to rock the established players off their socks. However, it hasn't happened so far.

Linear business models
A linear business model is one where output rises proportionally with inputs. There is little in the way of fixed cost (like software, or drug development, or chips manufacturing). This concept is behind our writings about a company like US Home Systems (NASDAQ:USHS). We noticed a rather accelerating (that is, 'non-linear') share price, while the business model suggest linearity.

The company produces mostly kitchen refacing products, what you put in, you get out, and then some (margin, which is not terribly high). It is a nice company and they're doing very well, but with a linear business model they can't keep producing a distinctly non-linear share price acceleration for too long, especially when the share price itself came into rather heavily overbought territory. That's how we spotted a few nice trading opportunities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Importance Of The Business Model