Understanding Business Models and Risks | CFA Level I Corporate Issuers

In this lesson, we will explore different types of business models and how they affect a company’s business and financial risks. We’ll learn the key features of business models, discuss some common types, and examine how digital technologies have brought about innovative business models.

What is a Business Model?

A business model is a company’s strategy for making money. It explains how the company aims to provide its products or services, attract customers, deliver to them, and make a profit. A business model is not a detailed financial plan but rather provides an overview of the value proposition, value chain, and profitability.

Value Proposition: The Who, What, Where, and How Much

The value proposition is critical to a business’s success. It comprises four main parts:

1. Target customers (who?)
2. Product offering (what?)
3. Channel strategy (where?)
4. Pricing strategy (how much?)

Firms selling to businesses (B2B) or consumers (B2C) have different target customers, product offerings, channel strategies, and pricing strategies.

Pricing Strategies: Finding the Right Fit

Now that we’ve explored the different components of a business model, let’s take a closer look at pricing strategies.

1. Value-based Pricing vs. Cost-based Pricing

Value-based pricing attempts to set prices based on the value or perceived value received by the customer. In contrast, cost-based pricing refers to setting prices based on the production cost, plus a profit. For instance, a law firm that bills clients by the hour employs a cost-based pricing model, while a law firm that charges based on successful outcomes uses a value-based pricing model.

2. Price Discrimination

Price discrimination is the practice of setting different prices for different groups of customers, based on their willingness to pay for essentially the same product or service. This strategy can take several forms:

• Tiered pricing: Pricing based on the volume of purchase, where the price per unit decreases as the quantity purchased increases.
• Dynamic pricing: Charging different prices at different times, such as off-peak pricing, surge pricing, or congestion pricing.
• Auction pricing: Establishing prices through bidding, like the system used by eBay.

Digital technology has made automatic price discrimination easier to implement and manage by analyzing demand, supply, and customer preferences.

3. Bundling

Some companies choose to bundle complementary products, incentivizing or requiring customers to purchase them together. Examples of bundling include hotel rooms with breakfast, mobile services with home broadband, and software packages combined as a suite.

4. Razors-and-Blades Pricing

In the razors-and-blades pricing strategy, a company sells an equipment cheaply, but the associated consumables are sold at a high margin. Printers and printer cartridges, and gaming consoles and game titles are some notable examples.

5. Optional Product Pricing

Optional product pricing allows customers to purchase additional services or features, either at the point of purchase or afterward. Companies can incentivize customers with a discount for selecting the option at purchase or charge a higher price when the customer requests the option after making the initial purchase.

6. Growth-oriented Pricing Strategies

For companies seeking rapid growth in market share, there are a few pricing strategies to consider:

• Penetration pricing: Offering a product at low margins or even at a loss to grow market share and achieve greater scale. This is particularly important for digital services that require a critical mass to succeed. For example, the Disney Plus streaming service was launched at a very low price to encourage sign-ups.
• Free trial: Limited-time free trials are also a form of penetration pricing.
• Freemium pricing: Offering customers some basic functionality for free while requiring them to pay for additional or more advanced features. Several online games employ this strategy, allowing players to play the basic game for free but requiring payment to advance levels or upgrade functionalities.

Value Chain: Delivering the Value Proposition

The value chain comprises a firm’s assets and capabilities critical to executing the business model. It describes how the company obtains these resources, whether owned or outsourced, and how it organizes itself to deliver the product.

According to Michael Porter, a firm’s primary activities are: inbound logistics, operations, outbound logistics, marketing, and sales and service. In addition, a firm’s primary “support” activities are procurement, human resources, technology development, and firm infrastructure.

Profitability: Measuring Success

Key metrics to consider for a business model’s profitability are expected profit margins, break-even points, and unit economics.

Types of Business Models

In the vast world of commerce, various business models have emerged to cater to different industries and customer needs. While we can’t cover every single one, we’ll focus on some of the more common and innovative types.

Traditional Business Models

For goods-producing sectors, traditional business models are often based on their position in the supply chain, such as:

• Raw material suppliers
• Manufacturers
• Wholesalers
• Retailers

On the other hand, service sectors boast a diverse array of business models, like:

• Insurance
• Brokerage
• Trading
• Investment banking
• Asset management

Digital Business Models

As technology continues to advance, we’ve seen the emergence of innovative digital business models:

• Platform business models: Companies like WeChat and social media platforms thrive on network effects, where the value of the network increases as its user base grows.
• Crowdsourcing: Platforms like Wikipedia and open-source software benefit from user contributions and collaboration.
• Affiliate marketing: These companies earn commissions by driving sales and leads to other websites.
• Marketplace businesses: Platforms like eBay and Alibaba facilitate transactions between buyers and sellers while taking a cut from the sales.
• Aggregators: Companies like Uber and Spotify curate and sell products or services under their own brand.

Hybrid Business Models

Some companies adopt a mix of traditional and digital models, creating hybrid business models. A prime example is Amazon, which combines product distribution with an online store and crowdsourced customer reviews.

Types of Risks Affecting Businesses

Three major categories of risk factors can influence a business’s long-term financial viability: macro risks, business risks, and financial risks. These risks are interconnected, with uncertainty in the economy trickling down to the industry and firm level, and then amplified by a company’s leverage levels. Let’s explore each of these risks in more detail:

• Macro risks arise from external factors affecting all businesses in an economy, such as changes in economic conditions (GDP growth, inflation, interest rates, and unemployment rates), demographic trends, social and political shifts, and changes in the legal and regulatory environment.
• Business risks stem from both industry-specific risk factors and firm-specific risk factors, which contribute to the variability of a company’s operating income.
• Financial risks result from the use of debt in a company’s capital structure, which increases financial leverage and amplifies financial risks.

Business Risks: Industry and Firm-Specific Factors

Business risk refers to the variability of a company’s operating income due to industry and firm-specific risk factors. Key industry risk factors include:

• Earnings cyclicality
• Industry structure (e.g., industry concentration)
• Competitive dynamics within the value chain (Porter’s 5 forces)
• Long-term growth and demand outlook

On the other hand, firm-specific risk factors can include:

• Competitive risks (e.g., losing market share or pricing power)
• Product market risk (e.g., demand lower than expected)
• Capital investment risk (e.g., sub-optimal investments)
• Environmental, social, and corporate governance (ESG) risks

Leverage: Amplifying Business and Financial Risks

Business risk is amplified by higher operating leverage, which is determined by the proportion of fixed costs in a company’s cost structure. Financial risk is amplified by financial leverage, which increases with the proportion of debt. These factors have profound implications on the type of business model a company adopts to manage risk.

Alternative Business Models for Managing Risk

Capital-intensive companies often incur substantial fixed costs and debt, which can lead to increased business and financial risk. To mitigate these risks, some companies may adopt alternative business models, such as:

• Asset-light models: Ownership of high-cost assets is shifted to other firms (e.g., franchising).
• Lean startups: Asset-light and outsourcing-focused, allowing for rapid scaling without significant capital investment.
• Pay-in-advance models: Reducing or eliminating the need for working capital by collecting cash from sales before paying suppliers.

Conflict of Interests Between Lenders and Shareholders

When deciding on a business model, a company must also take into account the conflicting interests of lenders and shareholders. Lenders prefer less uncertainty about earnings and lower leverage levels, while shareholders, despite being concerned about earnings volatility, tend to prefer higher leverage to increase growth potential and stock prices.

Conclusion

In summary, businesses are exposed to macro risks, business risks, and financial risks, which are interconnected and amplified by leverage levels. A company’s choice of business model can significantly impact its risk exposure, and firms must carefully consider the balance between risk and growth potential. By understanding the risks associated with their chosen business model and how leverage can amplify those risks, businesses can make informed decisions about their overall strategy and financial structure.