[BUSINESS MODELS & RISKS] CFA LEVEL I

BUSINESS MODELS & RISKS

Business Models & Risks

Business Models
( Section 2 to 4 : covering Los a
and b)

Risks
(Section 5 to 8 : covering Los c)

Section 1 – Introduction

A clearly described business model helps the analyst understand business operations,
strategy, target customers, risks and financial profile. Rather than rely on
management’s description of its business model, analysts should develop their own
understanding.

Many business models are complex, specialized, or new. Digital technology in

particular has enabled significant business model innovation, bringing business
models into the spotlight.

Section 2 – What is a Business Model? ( Los a)

A business model describes how a business is organized to deliver value to its

customers:

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 who its customers are,

 how the business serves them,
 key assets and suppliers, and
 the supporting business logic.
A clearly defined provides enough detail so that the basic relationships between the
key elements are clear, but it does not provide a full description that we would
expect to see in a business plan, such as detailed financial forecasts.

Business Model

Value Proposition Value Chain Profitability

Part 1 Part 2 Part 3

PART 1: VALUE PROPOSITION ( WHO + WHAT + WHERE + HOW MUCH?)

What is it? - The firm’s “value proposition” refers to the product or service attributes
valued by a firm’s target customer that lead those customers to prefer a firm’s
offering over those of its competitors, given relative pricing.

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4 Questions to Analyse

Who (Identifying the firm’s target customers)

• What Geographies will be served?

• What market will be served?
• What customer segments will be served?

What (Define what the firm offers (what product or service), interms that differentiate it
from competitor offerings, and with reference to the needs of its target customers).

Where ( Channel Strategy)–how it is reaching its customers? Generally involves:

• Selling the firm’s products and services and

• Delivering them to customers

How Much ( Pricing)

• Does the firm price at a premium, discount or at par relative to it’s competitors?
• How is the pricing justified in the Business Model?

What: Firm Offering

 Helps the analyst to understand the addressable market for the business and
to identify key competitors and associated risks.
 Common for companies to use overly broad terms in describing their offerings
or addressable markets, to overstate differentiation, or to reference platforms
or networks that may be very weakly developed—all in an attempt to convince
the analyst or investor of the value of the business– Analyst beware.

Where: Channel Strategy

Important to distinguish the functions performed from the assets that might be
involved and different firms that might be involved in performing those functions or
owning those facilities.

For Product businesses – Traditional Channel Strategy – Flow of Finished goods –

each with their own physical facilities.

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Direct Sales i.e. selling directly to the end customer( disintermediation). Involves the
company’s own sales force. common for complex or high-margin products or
services, such as industrial equipment, pharmaceuticals, and life insurance. It is also a
common strategy in B2B markets where the universe of potential customers is
relatively small and easily reached. With e-commerce, however, direct sales have
become a cost-effective strategy across many business and consumer markets.

Traditional Channel Strategy (Product) vs. Direct Sales Strategy

With Intermediary lies agency risk – requires the firm to give up a degree of control
to the intermediary.

In the e-commerce realm, the drop shipping model enables an online marketer to
have goods delivered directly from manufacturer to end customer without taking the
goods into inventory.
With an omnichannel strategy, both digital and physical channels are used to
complete a sale. For example, Ordering an item online and picking it up in a store
(“click and collect”) or selecting an item in a store and having it delivered.

Introduces potential cyber security and access risks, while having a physical location
might introduce substantially greater financial risk.

Important to recognize how a firm’s channel strategy differs from those of its
competitors. Example - Tesla references its direct sales strategy, which differs from
the franchised dealer model used by most automakers. Hyundai’s Genesis luxury

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cardivision also uses a no-dealer model, making visits to the customer’s home for test
drive appointments and for after-sale service appointments.

How Much : Pricing

Price Takers: Accept market prices dictated to them - pricing not essential part of
business model. (E.g.,– Commodity producing companies)– might emphasize other
sources of value like Cost Advantage. Might go for a discounting strategy to build
scale.

Price Setters: Companies commanding Premium Pricing – high differentiation – faces

much less pricing risk from competitors - Important for an analyst to assess whether
the firm requires access to specific capital, labor, or inputs to maintain its level of
differentiation.

Pricing Power depends on elasticity : lack of pricing power – product demand is

highly price elastic and vice versa.

Pricing and
Revenue Models

Value Based Cost Based

Pricing Pricing

Attempts to set pricing

based on the value received Attempts to set pricing
by the customer( E.g.– Tesla based on costs incurred.
: Total Cost of Ownership)

Price Discrimination

Common Strategies:

1. Tiered Pricing: Charges different prices to different buyers, most commonly

based on volume purchased.

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2. Dynamic Pricing: Charges different prices at different times. Example – Off-

Peak Pricing for Hotel Rooms during their seasons. Digital technology can make
this strategy much easier to implement and manage.
3. Auction/Reverse Auction Models: establish prices through bidding (by sellers
in the case of reverse auctions). Can be automated using digital technology
(E.g.– eBay for consumer merchandise, Amazon for digital advertising)

Pricing for Multiple Products

Common Strategies:

1. Bundling: combining multiple products or services so that customers are

incentivized, or required, to buy them together. Effective for complementary
products with high incremental margins or high incremental cost relative to
the product itself. E.g.– Cable TV and Internet Services; Tool-Kits, etc.

2. Razor and Blades Pricing: combines a low price on a piece of equipment(e.g.,

razor, printer, water purifier, or gaming console) and high-margin pricing on
repeat-purchase consumables (blades, printer ink, filter cartridges, software).

3. Optional Product Pricing: applies when a customer buys additional services or

product features, either at the time of purchase or afterwards. Seek higher
margins on optional features when the initial product has already been
purchased. E.g.,– A side order with a restaurant meal

Pricing for Rapid Growth

1. Penetration Pricing: discount pricing and is used when a firm willingly

sacrifices margins in order to build scale and market share. E.g.,– Netflix
(Subscription video).

2. Freemium Pricing: allows customers a certain level of usage or functionality at

no charge—for example, with news content, a software application, or a
game–provider stands to benefit from wide adoption (often via network
effects).

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3. Hidden Revenue Business Models: provide services to users at no charge and

generate revenues elsewhere. This is a common feature of both legacy and
digital business models in the media sector, with “free” content and paid
advertising.

Alternatives to Ownership

1. Recurring Revenue/Subscription Ownership: enables customers to “rent” a

product or service for as long as they need it. Traditionally associated with the
media sector, where firms provide access to standardized content that has a
low marginal cost(e.g., TV channels, magazines, streaming services, consumer
software). Wealth Management is a good example of this model where fee is
based on AUM instead of commissions charged for trades.
2. Fractionalization: creates value by selling an asset in smaller units or through
the use of an asset at different times. Examples include web hosting, which
enables sharing of server capacity, office sub-leasing/co-working(WeWork),
vacation property time shares (Marriott), and private jets(NetJets).
3. Leasing: involves shifting the ownership of an asset from the firm using it to an
entity that has lower costs for capital and maintenance. Example –
Automobile, Aircraft, Real Estate, etc.
4. Licensing: typically gives a firm access to intangible assets (e.g., a brand name
or intellectual property, such as a film library, song, or patented formula) in
return for royalty payments (often a percentage of revenues).
5. Franchising: A more comprehensive form of licensing –franchisor typically
gives the franchisee the right to sell or distribute its product or service in a
specified territory and to receive marketing and other support.

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PART 2 - VALUE CHAIN (HOW)

What is it? - The systems and processes within a firm that create value for its
customers.

Value chain analysis provides a link between the firm’s value proposition for
customers and its profitability. It involves:

1. identifying the specific activities carried out by the firm,

2. estimating the value added and costs associated with each activity, and
3. identifying opportunities for competitive advantage.

Michael Porter’s 1985 book Competitive Advantage defined five primary activities:

 inbound logistics,
 operations,
 outbound logistics,
 marketing, and
 sales and service.

In addition, a firm’s four primary “support” activities are procurement, human

resources, technology development, and firm infrastructure. This is a useful starting
point for an analyst evaluating the value chain of a company, although dramatic
advances in digital technology have radically changed the way that some of these
functions are carried out in many businesses.

Note: A firm’s value chain is different from a supply chain, which refers to the
sequence of processes involved in the creation of a product, both within and external
to a firm

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PART 3: PROFITABILITY AND UNIT ECONOMICS

A business model should also reveal how the firm expects to generate its profit. An
analyst will want to examine margins (generally Operating margin i.e. EBIT/Revenue),
break-even points (Fixed Costs/Contribution Margin), and unit economics, which is
expressing revenues and costs on a per-unit basis.

Business Model Features for Analysis

Section 3 --- Business Model Types

Business Model Variations

Private label or “contract” manufacturers :

produce goods to be marketed by others. This is an extremely common
arrangement, particularly for offshore production

Licensing arrangements:
a company will produce a product using someone else’s brand name in
return for a royalty– common in toys, apparel, etc.

Value added resellers :

not only distribute a product but also handle more complex aspects of
product installation, customization, service, or support. Common with
Industrial machinery, Air Conditioners, etc.

Franchise models:
distributers or retailers have a tightly defined and often exclusive
relationship with the parent company. Franchisee handles sales and
services using Franchisor’s (Parent’s) model and brand.

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E-Commerce Business Models

Affiliate marketing :
Performance Marketing - generates commission revenues for sales
generated on others’ websites.

Marketplace businesses :
create networks of buyers and sellers without taking ownership of
the goods during the process. Example – Alibaba, eBay, etc.

Aggregators:
similar to marketplaces, but the aggregator re-markets products and
services under its own brand. Example – Uber and Spotify

Network Effects and Platform Business Models

Network effects refer to the increase in value of a network to its

users as more users join. Serves as the foundation of most internet
based businesses.

Also, at work in many older, non-internet businesses, such as

telephone service, credit cards, real estate agencies, and stock
exchanges.

In some cases,network effects apply to two or more groups of users,

such as buyers and sellers in anonline marketplace, and can be
described as “two-sided” or “multi-sided.”“One-sided”network
effects apply in the case when users are a single, homogeneous
group.

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A platform business is based on a network and can be distinguished from a

traditional or “linear” business that adds value to something that is sold to customers
in a linear supply chain. Software companies for example, often have an essentially
linear business model. With a linear business, value is added by the firm; with a
platform business, value is created in the network, outside the firm.

Crowd sourcing Business Models

Crowdsourcing business models enable users to contribute directly to a product,

service, or online content. Example – Wikipedia, Waze/Google Maps, Etc. Many of
these examples involve “user communities” that enable voluntary collaboration
between users of a product or service, typically with little to no oversight.

Hybrid Business Models

Combining platform and traditional “linear” businesses, are also common. For
example, Amazon’s core business has both traditional elements (goods distribution)
and platform elements (online marketing and advertising). Tesla sells cars(via a linear
model), but its customers benefit from an expanding network of charging stations.

Section 4 --- Business Model : Financial Implications ( Los b)

Businesses have very different financing needs and risk profiles, depending on both
external and firm-specific factors, which will determine the ability of the firm to raise
capital.

External Factors

1. Economic Conditions: Macroeconomic variables like GDP Growth, exchange

rates, interest rates, credit environment, inflation, etc.
2. Demographic Trends: Unlike economic forecasting, long term forecasting can
be done with high accuracy, since, the underlying drivers ( birth, death,
immigration rates) change very slowly.

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3. Sector Demand: Varies by Industry. Depends on cyclicality. Business cycle

tends to have less effect on demand for products that are non-discretionary
and consumed immediately than on demand for long-lived products or assets.
4. Industry Cost Characteristics: such as Capital Intensity and Operating leverage
also varies by industry. Businesses with low variable costs and high
contribution margins have high “operating leverage” and are said to be
“scalable,” with operating margins expanding rapidly as business revenues
grow.
5. Political, Legal and Regulatory Environment: Includes the institutions, laws,
regulations, and policies that affect the business. While businesses often balk
at regulations, the same regulation can serve as barrier to entry.
6. Social and Political Trends: Shifts in public opinion and tastes often precede
changes in consumer buying behavior or the political/legal environment

Firm- Specific Factors

1. Firm maturity or stage of development of the business: Start-Ups and Early

Stage companies typically require more capital – presents more business risk
than a more mature business.
2. Competitive position: Companies with strong barrier to entry ( Wide Moat) has
low business and financial risk, cet par.
3. Business model: A firm’s decisions about which assets and resources to “own”
rather than “rent” are often driven by its business model and will greatly affect
its financial profile.

Lean Startups:
Asset Light Business
Extend this logic to Pay in Advance :
Model :
human resources, Reduce or eliminate the
Shift Ownership of High
outsourcing as many need forworking capital
Cost assets to other firms.
functions as possible.

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Section 5 & 6 --- Risks (Los c)

Business risk encompasses factors related to the business itself and the industry in
which it operates.

The perspective of debt and equity investors is different but has many common
elements. Debt holders expect the timely repayment of principal and interest, with
interest paid timely at an agreed-on rate. They must consider the risk that the
borrower will default and if that occurs, the likely magnitude of their loss. For equity
investors, the potential for loss is more complicated. Their returns consist of
dividends received and changes in the value of the business, which, in turn, hinge not
only on how the business performs but also on changes in expectations for future
performance. Both consider the cash flow–generating ability of the business as an
indicator of future performance.

Risks

Macro Risk Business Risk Financial Risk

Macro Risk

 Risk from political, economic, legal, and other institutional risk factors that impact
all businesses in an economy, a country, or a region. In most situations, principal
macro risk – risk of potential slowdown or decline in economic activity.
 Some industries are relatively insensitive to economic activity levels (e.g., utilities,
consumer staples),whereas others are more sensitive (e.g., capital goods and
consumer discretionary goods, such as jewellery and vacation travel).

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Business Risk

 Risk that the firm’s operating results will be different from expectations,
independently of how the business is financed.
 Variability of EBIT
 Includes Industry Risk and Company Specific Risks

Financial Risk

 Risk arising from a company’s capital structure and, specifically, from the level of
debt and debt-like obligations (such as leases and pension obligations) involving
fixed contractual payments.
 Can also create the possibility of Default Risk and Financing Risk.

The impact of risks on a business and the returns debt holders and equity investors
earn from the business is cumulative.

Section 7--- Business Risks (Los c)

Business
Risks

Industry Company
Risk Specific Risk

Industry Risks: include risk factors likely to affect the overall level of demand, pricing,
and profitability in the industry.

1. Cyclicality: a feature of many industries and Inputs, particularly discretionary

goods; housing; durable goods, such as autos and appliances; and capital
equipment. Firms attempt to mitigate the impact of cyclicality by entering into
Long Term customer or hedging contracts. Higher the cyclical nature of
business, more conservative the capital structure policies.

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2. Industry Structure: Level of concentration in the industry. Lower the

concentration, higher the competition – generally service sector, local firms
having high product differentiation. Concentration measured by HHI.
3. Competitive Intensity: Influences overall industry profitability. Metrics like
ROIC and Operating profit margin used.
4. Competitive Dynamics within Value Chain: potential profitability pressures
from the interaction of buyers, suppliers, current and potential competitors,
and suppliers of substitute goods. Porter’s 5 forces.
5. Long Term Growth and Demand Outlook: more a determinant of industry
attractiveness than of risk, but an unexpected falloff (or absolute decline)in
growth can result in excess capacity and more aggressive competition.
6. Other Industry Risks– Regulatory and other external risks.

Industry definition should not be too broad nor should it be too narrow.

Company Specific Risks

Company-specific risks vary based on the nature, scale, and maturity of the
business.

1. Competitive Risk: risk of a loss of market share or pricing power to competitors

and often reflects a lack of competitive advantage. Also arises from potential
for disruption.
2. Product Market Risk: risk that the market for a new product or service will fall
short of expectations. Generally not a concern for mature businesses, but a
very big concern for Early Stage (Pre-Revenue) businesses.
3. Execution Risk: possibility that management will be unable to do what is
needed to deliver the expected results. Execution risk tends to be accentuated
by other business risks.
4. Capital Investment Risk: the potential for sub-optimal investment by a firm.
Generally a big concern for Matured businesses.
5. ESG risk: Governance Risk

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6. Operating Leverage: Sensitivity of a firm’s operating profit to a change in

revenues. For businesses that are struggling or facing declining demand, high
operating leverage can be problematic and is a source of business risk.

Section 8--- Financial Risks (Los c)

Financial risk (as distinguished from business risk) refers to the risk arising from a
company’s capital structure and, specifically, from the level of debt (and other debt-
like obligations, such as leases and pension obligations) involving fixed contractual
payments.
Financial risk is closely related to the variability of profits and cash flows. These, in
turn, depend on the predictability, or volatility, of the revenues and operating cash
flow (i.e., business risk). Financial risk thus reflects the cumulative impacts of macro
and business risk.

A business with a low level of business risk can typically support a high level of
financial leverage and is generally one with demand that is predictable and stable, a
strong and durable competitive position, and high operating margins and that does
not require large amounts of investment to maintain its position.

Measuring Operating and Financial Leverage

Total leverage can be broken down to several components :

Total leverage = Operating leverage × Financial leverage.

Here, operating leverage captures the sensitivity of operating profit, proxied by EBIT,
to a change in revenues and can also be calculated as follows:

Operating leverage = Contribution/EBIT.

Financial leverage reflects the variability of profits introduced by interest charges—

that is, the sensitivity of net profit to a change in operating profit. It can also be
calculated as:

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Financial leverage = EBIT/EBT.

Note that this approach refers to EBT rather than net income, since taxes fluctuate,
but would normally be a stable percentage of EBT. For this reason, we can also
measure financial leverage as the percentage change in EBIT divided by the
percentage change in earnings or EPS.

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