11 types of business models all investors should know

As an investor in equities or debt of companies its important to understand different types of business models and what are the valuation drivers for those business model. Investors can then understand the impact on asset prices based on developments.

1 Trading businesses

These businesses purchase inventory, store it and sell it to other businesses

These are Working Capital heavy businesses with low Fixed Assets

Examples of these businesses include distributors of vegetables, electronics, pharmaceuticals, etc. Businesses in these categories buy inventory and mark up prices to ensure 10-20% Gross Margin. They then try and complete one to four inventory turns in a year so as to achieve a 10-20% Return on Equity.

Conventional metrics such as P/E, EV/EBITDA are used to value these companies

2 Multi-brand retail businesses

These businesses usually having low Gross Margins (around 10-20%), and PAT margins of 5% or lower. However, their Working Capital is negative as they push their vendors to accept late payments

Conventional metrics such as P/E, EV/EBITDA are used to value these companies

3 Consumer goods and FMCG

These businesses manufacture and market branded foods, apparel, footwear and these products could be used for staple or discretionary consumption.

Businesses in this category have generated several wealth creators such as The Coca Cola Company Limited in the US, Page Industries in emerging markets such as India and there are several other examples.

As these businesses become larger, they start outsourcing most activities apart from marketing, sales, strategy, and IP protection. They outsource manufacturing as well. This outsourced model makes these companies more capital efficient. Businesses in these categories that address staple demand (think of sauces, undergarments) also see little impact on sales even during adverse economic environments. For this reason, companies in this space have had a strong record of value creation of shareholders.

Conventional metrics such as P/E, EV/EBITDA are used to value these companies. Companies in this space get early stage interest as well and are often valued on sales multiples before profitability is achieved.

4 Infrastructure owners

These companies own assets such as ports, roads, power plants, railways, and other such infrastructure. Projects in this space are usually expected to have predictable cash flows and Return on Equities in the early double digits. Therefore, these companies are usually invested into by investors seeking lesser risk. However, financial performance of these companies is highly depended on interest rate dynamics as these assets are usually built by taking on debt and servicing that debt through cash flows. For the lack of a better comparison, think of a person who buys a house using debt and pays off the EMIs from his salary – over time this individual’s home equity goes up – this is similar to how equity values of these infrastructure projects behave. IRR is a complex mathematical function and a metric that is often used to give an indication of the IRR is Payback. Payback is defined as the number of years in which the investment in capex and working capital is received by the company. As an example, if a company spends USD 100 to setup a project and it recovers USD 40 in year 1, USD 35 in year 2 and USD 25 in year 3, then the project is said to have a payback of 3 years. For infrastructure projects payback periods typical stretch for 7 years and above.

Conventional metrics such as P/E, EV/EBITDA are used to value these companies

5 Engineering companies that build infrastructure

These companies build out infrastructure such as Siemens or Larsen and Toubro (in emerging markets). Payments are made to companies based on achievement of milestones.

Performance of these companies is very dependent on delays in approvals from governments, change in interest rates, change in commodity prices and other such factors. These businesses have created value in stable regulatory environments but have faced hurdles in emerging markets wherein the regulatory environment is susceptible to change.

Conventional metrics such as P/E, EV/EBITDA are used to value these companies

6 Technology companies

a B2B software products and SaaS companies

Software companies have extremely lucrative business models. They are not capex heavy, have IP and are growing rapidly due to increasing technology adoption globally. Several software companies have now moved to a SaaS (“Software as a Service”) model. In this model, a significant component of customer acquisition and the product/delivery occurs over the internet. It is because of this that SaaS companies have very lucrative business models. Due to the internet their cost of acquisition and servicing the client is much lower and it is easier to scale.

b Consumer internet

These companies include categories such as ecommerce, online classifieds, digital content sites among others. Many of these businesses have also proved to be robust generators of shareholder value. Examples include Facebook, Alphabet, Amazon and several others. Several businesses in this category are currently unprofitable but receive robust valuations because of what they can potentially become – asset light businesses with very unique data-based IP related to consumers.

In the steady state these businesses achieve high return on equity metrics as well rapid growth. For this reason, these companies trade usually at multiples that are much richer than the broader market.

7 Financial services

a Banks

Banks raise debt from individuals (checking accounts, fixed deposits), companies (checking accounts, fixed deposits), capital markets (debentures). Banks then lend this capital as business loans, housing finance loans, consumer loans, etc. Depending on the region, banks are able to raise debt up to about 7 times the equity capital. Banks are significantly regulated due to potential adverse implications on financial stability for depositors and the broader financial system.

Valuation: As these companies do not have any depreciation and grey areas in accounting norms can skew Net Income, Book Value is often used by the market to derive valuation. For this reason, most financial institutions have their valuation analyzed using Price/Book Value

b Non bank finance companies

These companies raise debt capital from banks and other financial institutions. They further lend to individuals and companies. As their cost of capital is higher than banks (since they raise money from banks), these NBFCs lend at higher rates than the rates offered by banks. Due to this the risk profile of their investments is higher than the risk profile of the entities that banks lend to. NBFCs also differentiate themselves from banks by offering flexible investment structures and lesser collateral requirements.

c Asset Management companies

These companies include mutual fund managers, private equity fund managers and other type of investment companies that manage different type of funds. These companies earn asset management fees (usually 0.5-3%) of capital managed for individuals, corporates and other entities.

d Brokerage companies

These companies offer trading accounts to retail and institutional clients. They earn revenues through commissions, bid-ask spreads and financing charges for trading leveraged products. Many of the research reports that we come across are published by these companies as these reports helps their clients in decision making.

e Investment Banking

Investment banking firms help companies in raising capital or acquiring companies. These firms earn 0.5-3% typically on transactions they close. As one can imagine, if large transactions are closed then these companies can make some hefty revenues. From the revenues, large bonus pools are created for the investment banking and the remaining amount is kept for shareholders of the firm.

f Trading firms

These firms trade stocks, bonds, commodities, forex and other financial instruments using several strategies. Firm using their own capital to trade are referred to here. Those that trade using outside capital are Asset Management Companies that are mentioned in section (c) above.

g Credit card companies

These companies provide credit card solutions to consumers and companies. Bulk of revenues for credit card companies come from charging a transaction fees to merchants. Merchants pay 2% of all transaction values that are carried out through a credit card. This 2% is divided between 3 entities – most of it is kept by the bank that issues the credit card, some is kept by the payment processing company that has kept the PoS (Point of Sale) terminal at merchants and some is kept by the interchange network that is being used (Visa, Mastercard, etc.). Merchants are willing to pay this 2% because without using a credit card their cash management fees anyways exceed 2% of transaction value and also consumers have displayed a propensity to spend more when they have instant credit and payment ease that is offered by a credit card. Credit card companies also earn some additional fees by sometimes charging consumers annual fees for using the credit card, late payment fees as well as fees earned by some other tie ups with other service providers such as through gym memberships, lounge access, etc. For credit card issuing companies the transaction fees offer a profitable business even after accounting for about a month’s free credit to consumers. Examples of such companies include American Express.

Valuation: Price to earnings and EV/EBITDA

h Payment processing companies

These are companies that focus exclusively on the payments space and many times have similarities with the aspects described in section (g) above. Interchange companies such as Visa, Mastercard offer the technical infrastructure that enables credit cards and debit cards. Companies such as PayPal are digital wallets that keep the entire fees that are charged to merchants and because of their models do not have to share any fees with companies such as Mastercard, Visa, etc. These digital wallets also earn income on the cash left with them by consumers. Online payment processors such as Adyen and Billdesk have built technological platforms that play a similar role to offline Point of Sale management companies described in section (g) above. Because of the rapid growth in ecommerce globally, these companies have already built scale and are forecasted to grow further. These companies also have data on the spending patterns of their users which provides them further insight into what other products and services these users can purchase. Therefore, many of these companies have started providing additional products on their platforms such as digital lending, credit analytics, offering investment products, etc. Many ecommerce companies have started offering their in-house payment platforms to their users. This has helped them offer payments to their customers and capture this lucrative economic activity as well. Examples include Alipay by Alibaba, WeChat by Tencent, Phonepe by Flipkart, Apple Pay by Apple.

Valuation: Price to earnings and EV/EBITDA

8 Insurance

As we have seen, a bank raises capital from consumers as well as businesses by paying a certain interest and then lends that capital at a rate higher than the cost in the form of consumer, business loans. Insurance companies have certain similarities to this model. In the manner banks raise capital from consumers by providing some interest, insurance companies raise capital from consumers by insuring against certain events such as death, health, accidents etc. The insurance company then diversifies the risk across several consumers such that the claim amount is lower than the total insurance premium collected. The insurance company uses data analytics and hires ‘actuaries’ who specialize in calculating likely loss from different insurance related activities. In addition, insurance companies invest the capital that they collect from premiums and invest the same in capital markets. Similar to banks, regulators do not allow insurance companies to make very risky events. The ‘Claim settlement ratio’ is the number of actual claims upon the premiums collected. Insurance companies undertake actuarial analysis to ensure the claim settlement ratio is less than one and price their claim premiums accordingly. in the way that banks are leveraged about 7 times on the equity, insurance companies are also leveraged by similar number of times when looked at the premium raised upon equity.

a. Life insurance

Life insurance companies earn premium from individual for insurance against loss of life and try and make profits by diversifying the potential claims across large number of individuals. As described above, these companies ensure they earn more on the premiums received after factoring for claim settlement ratios. Life insurance companies are among the largest companies in the geographies that they operate in.

b. General Insurance and Auto insurance

These companies insure against events related to fire, natural disasters, theft, forgery and other such unforeseen events. As described above, these companies ensure they earn more on the premiums received after factoring for claim settlement ratios.

c. Health insurance

These companies insure against medical events such as sickness of individuals or a group of individuals. As described above, these companies ensure they earn more on the premiums received after factoring for claim settlement ratios. In several countries, health insurance is mandatory for employees thereby creating a ready market for these companies.

9. Healthcare and Lifesciences

a. Hospitals

These companies tend to have long gestation periods and generate revenues from retail payments as well as from health insurance companies. Similar to heavy capex investments like we saw in Section 4 above, hospital tend to target a certain utilization of its bed capacity so that capital IRR targets are met. While hospitals also get outpatient (patients who do not get admitted), inpatient (patients who are admitted) patients account for around 80% of hospital revenues. Hospitals try and optimize ALOS (Average Length of Stay), Revenue per patient

b. Other healthcare services

This category includes diagnostic chains, eye care chains, dental chains, chains that deal in other medical specialties. The economics of these chains are similar to chain of hospitals. A location is chosen for any center if a target payback of 3-4 years typically can be achieved. This would also mean that capacity utilization can be achieved in order to ensure that payback targets are met.

c. Pharmaceutical companies

These companies have economic models that are at times similar to FMCG companies described in section 3 above. Pharmaceutical companies are usually of two types – the first type own the exclusive right to sell a particular type of medicine – a right they obtain by owning the patent of a particular medicine. Patents for such medicines are provided by law for a number of years. Once a medicine goes ‘off patent’, it becomes a ‘generic’ medicine. A generic medicine can be manufactured by any pharmaceutical company. After a particular medicine or compound becomes generic, its price in the market drops significantly and accordingly so do the margins of any company that focuses on that particular compound or medicine. A third category that has emerged in recent decades has been biological companies. These companies use more ‘biological’ or naturally occurring chemicals in developing products that act as medicines.

d. Pharmacies

Economics of these companies are similar to multi brand retail stores that were discussed in section 2 above. However, they function under the purview of more regulatory restrictions. Each pharmacy is usually required to have a qualified pharmacist and many medicines can be sold only if there is a doctor’s subscription. Pharmacies make profits from selling Nutritional products.

10. Media

a. Newspapers

These companies generate revenues by selling advertising in newspapers and by selling newspapers to subscribers. Newspapers also have digital offerings which generate revenues through digital advertising and premium subscription to users.

b. Production companies

These companies produce movies and TV serials. Cash profile of these businesses depend on whether they are producing serials or movies. In the case of TV serials, production of a few series takes place followed by an outright sale to a TV channel. In the case of movies, production takes place over months (sometimes years as well) and then most of the revenues are generated upfront by sale to a film distribution company. In some cases, some royalty revenues are earned by the production company in future years depending on agreements with the distribution company.

c. TV channels

Revenues are generated from advertising and in some cases, subscription fees paid by end users. Most of these companies produce their own shows as well.

d. Direct to home TV companies

These companies provide set top boxes through which retails users access television channels in homes. TV Channels pay ‘carriage fees’ to these companies to have their channels on the set top box. These companies may outsource manufacturing (in which their Balance Sheet will be light) or they may manufacture themselves (in which case the Balance Sheet may contain significant Fixed Assets).

11. Telecom companies

Telecom companies purchase license for appropriate frequencies from the government and then use those frequencies to provide telecom services to retail users.

Disclaimer: Vitspan does not provide any investment related, tax related or financial advice. The information presented is done so without considering the investment objectives, risk profile, or economic circumstances of any reader or investor. The information presented may not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the potential loss of principal. Please consult your financial advisor prior to making investment related decisions.