What Are Scalable Business Models?
Even though the Internet stock bubble eventually burst, one thing should be kept in mind. The Internet created the possibility of very scalable business models. Despite what happened to Internet stocks in general, the right investment in a good scalable business model could still prove to be a great investment. What are scalable business models?
Business Models
he term “business model” refers to a very simple concept: how a company receives revenues in exchange for value delivered. If you have a good understanding of a company's business model, you can understand how the earnings of a business respond to growth of the business.
To understand any company's business model, you need to ask the following questions:
- Who pays the company?
- What does the company do to deliver the value, and to whom?
- What does it cost the company to deliver that value?
- How does the company get paid when more of its services are consumed?
There are many business models where the person receiving the value is not the one paying the revenues. Broadcast television is perhaps the best example. TV is free, but advertising pays for delivery.
Although it seems like a simple concept, there were, and still are, companies that became public in the Internet boom without well thought-out business models, scalable or not.
Many Internet business models didn't pass basic tests of credibility. For example, sites with pure advertising models are usually unable to answer the most basic question about growth: how big can you get? The reason is that growth is entirely dependent upon increased page views, either by more users, or more pages, offset by declining ad rates.
Both have upper limits and most companies with advertising models have fixed costs exceeding current revenues. When you try to compute how many page views a pure advertising model needs to generate just to cover fixed costs, it is usually baffling.
Scalable Business Models
A scalable business model is also a simple concept. A scalable model is one where:
- Increased revenues cost less to deliver than current revenues
In other words, the operating margin increases as the company's revenues grow.
Technology's greatest achievements have all been associated with scalable business models.
Fixed Costs and Variable Costs
Another way to think about scalable models is to look at a company's fixed costs versus variable costs.
Fixed costs are costs that a company incurs whether it sells or not.
Variable costs are costs that a company can control, or which it incurs as it makes sales.
A company with a scalable business model will have variable costs that are small, per unit, or discretionary, as in R&D. The fixed costs should be ignored so long as you believe that revenue will be large enough to exceed the fixed costs.
Not Economy of Scale
A scalable model is not the same as economy of scale. The phrase economy of scale means that a company's variable costs become lower as the company gets bigger. In addition, fixed costs can be spread over a greater number of units sold. This helps earnings, but economy of scale does not ensure that operating margins increase as revenues increase.
Cost of Goods Sold
Another way of understanding a scalable business model is to examine the relationship between cost-of-goods-sold and revenue. Companies that have a very low cost-of-goods-sold percentage generally have an opportunity for a scalable model.
Gross margin is the difference between revenue and cost-of-goods-sold. If the cost of sales and marketing, per unit or per customer, is less than the gross margin, then the company's model is scalable. For every dollar spent on marketing, more than a dollar is generated in gross margin, provided there is demand.
Revenue, cost-of-goods-sold, sales and marketing, can all be read from a company's earnings report.
Demand
Scalable business models have the potential for earning high profits. That potential is only fulfilled when demand drives revenues up. Finding a scalable model is one thing. Finding a scalable model with evidence of booming demand is the ideal situation for an investor.
Examples
The most common example of an established scalable business model is software. Developing software costs a tremendous amount but delivering a copy of that effort costs next to nothing.
Microsoft takes the concept of scalability further than any other software company because it provides only a single image of the Windows operating system to hardware vendors. The hardware vendors absorb all the charges for developing documentation and CD-ROM copies of software. In essence, Microsoft receives revenues with zero cost-of-goods sold.
The Internet is unique in that it is creating software delivered electronically which is the best of both worlds. The application software world, where software was delivered in a shrink-wrap box, had costs associated with each unit sold.
The Application Service Provider (ASP) model delivers software at no additional cost per user. Provided that ASPs can charge for services on a per user basis, the ASP model is very scalable.
Searching For Scalable Business Models
There are two ways to search for possible investments in scalable business models:
- Look for companies that sell items with low cost-of-goods sold percentages.
- Use a stock screening database that allows you to compare the percentage increase in revenues with percentage increase in operating margin.
If you can uncover an existing company that has a scalable business model, and the market has depressed the price, it may be a great investment.
