A business model is the overall strategy that defines how a business makes its money. Having the right business model is essential and investors often need to assess the business model to estimate the future potential of a company.
This is best illustrated by some examples:
- Selling a high volume of products at a low gross margin: e.g. supermarkets.
- Selling a low volume of products at a high margin: e.g. luxury goods.
- Offering content or services free and making money from advertising: e.g. many websites and free newspapers.
- Selling a product cheap to increase sales of other products: e.g. loss leaders to increase footfall or a razor-blade model, pricing a complementary good low.
There are a number of questions an investor needs to ask about a business model when thinking about the future prospects of a business. The important is Often whether it is sustainable: for example a specialist retailer may be threatened by supermarkets.
For a growth business it is important to consider whether it is scalable: whether the business model can handle growth. Here we are talking about limits to growth internal to the business, as opposed to external constrains such as the size of the market and market penetration. Typical limits are imposed by supplies, skilled labour, resources such as suitable locations for shops, and by the difficulty of managing an expanding business. The last may be less obvious: it occurs, for example, in an expanding chain of shops as management have less time to supervise each location or region.