A Guide To Identifying A Winning Business Model

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Mastering equity investing isn’t just about knowing how to read spreadsheets and reports, or understanding financial valuations.

Retail investors also have to interpret and assess a company’s strengths and weaknesses in order to make a informed decision whether or not they should invest in it.

A commonly mentioned subject is the strength of an entity’s business model. Depending on how you view it, this might be a area which can seem quite abstract.

While statistics like earnings and revenues are understandable from the get-go, intangible factors such as scalability and economic moats can seem much more vague.

With that said, it’s undeniable how important this aspect of a business is. A strong business model can be the difference between a poor investment, and an excellent one.

There are many factors which determine a great business model, here are 4 which we have identified and we think are crucial considerations for investors.

Profit Margins

One of the core competencies of a business is it’s ability to create value for it’s customers by combining the manpower, skills, and resources available to it into a profitable product or service.

The difference between the cost of resources used by the company to the selling price of the end product is equivalent to it’s profit margin, which is how much perceived value the entity creates.

This perceived value is what separates a great business from a good one, as it shows that the company is able to create more value for the customer as compared to a mediocre one.

To quote an example, we can look at the profit margins for both Apple and Xiaomi.

Although both companies are in the smartphone trade, we can see that the margins for Apple grossly outperforms that of Xiaomi, likely due to various intangible factors such as perceived quality and branding.

Furthermore, such excellent profit margins support the company’s financials by providing more cash flow for it’s day-to-day operations and expansion activities.

Total Market Size

The concept of the total market size comes from the opinion that all products and services have a “max cap” on it’s market demand.

This cap is determined by a suite of factors, such as local population size, frequency of usage, and how essential it is to customers.

It’s quite difficult to calculate this market size accurately, but a common formula is to multiply the singular revenue of a product or service by the total possible number of customers to get the market size.

Admittedly, this method of calculation might not suffice for all trades, as information may or may not be easily available to investors.

Another solution is to simply retrieve said information from reputable research firms such as Gartner, Forrester, and IDC Research. This would be less effort intensive for retail investors.

Total market size matters to prospective investors as it reveals the amount of possible revenue the business entity can derive from it’s customers by addressing their current and future demands.

Naturally, a company who is able to harness this demand and grow it’s market share will attract more investors willing to pay more for it’s stock, rewarding early shareholders.

Scalability

Tying in with the previous point about capturing demand, a great business model would ideally be scalable to it’s customer’s needs.

Scalability describes a company’s ability to grow without being hampered by its structure or available resources when faced with increased demand.

Nowadays, this attribute is expected in Technology, Data, or Cloud businesses which have minimal physical requirements, but can manifest in other businesses in varying degrees.

An example would be property agencies like Propnex, and APAC Realty. These agencies are able to capture the surge in property transactions as property prices shot up, allowing them to profit greatly from sales commissions.

For Industrials, the concept of Capacity Utilization comes into play. This metric refers to how much of a factory’s production capacity is currently being utilized.

A factory with a capacity utilization rate which is not maxed out would be able to accommodate surges in demand by producing more goods without the need to expand it’s production facilities.

Of course, this is assuming the raw materials which it uses is in adequate supply, which may not always be the case.

Economic Moat

The last point is a catch-all term for any distinct advantage a company has over its competitors which allows it to protect its market share and profitability.

It is often an advantage that is difficult to mimic or duplicate and thus creates an effective barrier against competition from other business entities.

Commonly stated moats include excellent brand identity, cost advantages, product or service specialization, or having a technological edge over it’s competitors.

Examples include companies like Nanofilm Technologies, whose advanced nanotechnology segment allows them to manufacture intricate products which other Industrials are incapable of due to their lack of expertise.

Going back to Propnex and APAC Realty again, although there are many property agencies in Singapore, their exceptionally large agent pool allows them to attract developers who want to promote new residential offerings effectively.

To emphasize, such advantages allow these companies to drive increased profits over the long term, which would also benefit their shareholders greatly.

Conclusion

While some companies are recognized for their excellent business models and valued accordingly, there are others which stay hidden away.

Savvy investors who are able to sniff out such gems, coupled with the patience of holding them for the long-term, could find themselves holding stocks with tremendous potential.

Even without having the full suite of the above mentioned features, companies which carry some of these attributes can also be great investments, if priced correctly.

Ultimately, the strategy is really to identify, follow, and buy into these opportunities before the market catches on to their potential.

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