What would be the one question you would ask a room full of experienced investors, future analysts, or even company executives as a measure to determine their knowledge of a business? That is a profoundly simple question to the most accomplished financial thinkers in the world, Warren Buffett included, and Michael Mauboussin, as well as many others.
The simplicity is deceptive. This is not the question to be unpacked in a search to get a one-line answer in an annual report. It is the most fundamental, fundamental and most essential skill that any financial or business analyst can put together. It is art and science of going deeper than the superficial measures and share price talk to see the core economic driver of a business. In a data-rich world, the skill deep into interpreting the actual revenue model or monetization structure of a company, that is, becoming an expert in the monetization structure of a firm, distinguishes the superficial commentator of the astute analyst.
This blog will explore the importance of this skill as the priority, decompose the key elements of a revenue model, offer an analysis framework, and demonstrate how the ability to answer this question in the best way results in better investment decisions, strategic acuity, and professional achievement.
The reason why it is the foundation of analysis.
It is important to know the reasons behind before plunging into the how. Why is such single focus so powerful?
It Cuts through the Noise: Tech and innovation companies may be characterized by their vision, their total addressable market (TAM), or the number of users. Although they are significant, they may be distractions. The analysis is based on reality; it is understood how money actually flows between the customer and the company. A million users cannot be relevant when the route towards monetizing the same is faulty or otherwise absent.
It Uncovers the Health of the Business Model: The revenue generation structure determines it all: the cost structure, its scalability, customer retention, and competitive edge. When a firm generates revenue through transactional sales, this creates a disparity in the risks and opportunities compared to a firm that is dependent on recurrent subscriptions.
It Drives Valuation: Simply stated, the present value of future cash flows is valuation. It is impossible to start predicting such cash flows without knowing the drivers, durability and growth levers of the revenue stream. Is revenue predictable? Is it restricted to a single situation, or is it a lifelong relationship? The responses have a direct influence on the multiple the market gives.
It Finds Major Risk and Dependency: Does the company have a single big customer? Is its revenue cyclical? Does it face technological disruption on its payment mechanism? The knowledge of the money trail raises the weaknesses of the business.
It Nurtures Strategic Acumen: To strategy advisors (equity researcher, management consultant, or corporate strategist), this is a skill that cannot be compromised. Without a fine-grained knowledge of the already in place profit formula, you cannot recommend a new market entry, a product launch, or a price change.
Concisely, when financial statements are the scorecard, the revenue model is the playbook and rulebook of the game. Without knowing the rules, you can not appreciate the score.
Breaking down the Engine: The Elements of Revenue Generation.
To answer the question how does it make money. leads to the exploration of multiple layers. We shall construct the analytical framework.
Layer 1: The Core Revenue Streams- The What.
The simplest category is what is being sold by the company.
Products vs. Services: Is it a tangible good (the iPhone by Apple, Ford F-150) or a service (Netflix streaming, Salesforce CRM interface). It is typical to have hybrid models (e.g., IBM sells consulting and hardware).
Licensing vs. Owning: Is it a perpetual license (traditional software) or a subscription (SaaS), which is purchased by the customer?
Transaction vs. Relationship: Does the company make money on a per-sale basis (eBay receiving a commission on every sale) or does it make money on a monthly contract (a telecom phone plan)?
Level 2: The Monetization Model - The How.
This makes up the payment mechanism. It's the heart of the analysis.
Volume/Unit-Based: Money is earned on the basis of a unit of physical sale. Consider Procter and Gamble (a bottle of Tide), Toyota (a car). The most important measures: volume, price/unit.
Subscription/Recurring: Subscribers are required to pay a recurring amount to be able to access it. This will result in known, clingy revenue. Examples: adobe creative cloud, the gym membership. Measures of importance: Monthly Recurring Revenue (MRR), Annual Recurring Revenue (ARR), churn rate.
Transaction/Commission-Based: This is where the company makes a deal and receives a percentage or commission fee. Airbnb (guest/service fee) and Visa (interchange fee) marketplaces and payment processors do well in this regard. Important figures: Gross Merchandise Volume (GMV), take rate.
Advertising-Based: The item (in many cases, content, a platform) is free or subsidized, and the earnings are generated through the advertisers paying to reach the user base. This model is used by meta (Facebook), Google search and the traditional TV networks. The most important metrics are active users, average revenue per user (ARPU), cost per click (CPC).
Freemium: This is a combination of advertisement and subscription. The most basic one is free, and more advanced functions have a paywall. The archetypal ones are Spotify and LinkedIn. Measures of interest: conversion ratio of free to paid, paid user growth.
Licensing/Franchising: The firm transfers rights to its intellectual property, brand or system. Coca-Cola franchises its syrup, McDonalds franchises its restaurant concept. Critical ratios: royalty rate, franchise fees.
Project/Fee-for-Service: payment depends on the accomplishment of a certain project or provision of professional hours. Usual with consulting (Accenture), law firms, and construction. Measures of critical importance: utilization rate, billable hours, project margin.
Layer 3: The Pricing Power - The Whys.
This is the qualitative get down of the thing. Is the company able to increase prices without any loss of customers? This is a function of:
Value Proposition: Is the product or service resolving a severe pain point or generating outstanding happiness? Is it a good-to-have or a bad-to-have?
Competitive Moat: Does the company possess any long term advantages (brand loyalty (Coca-Cola), network effects (Facebook), high switching cost (Oracle databases), and low cost (scale of Amazon)) that is fine-tuning its prices?
Product Differentiation: Whether it is commoditized (price is the distinguishing factor) or unique.
A company with strong pricing power has a healthier, more resilient revenue model than one competing solely on price.
layer 4: Unit Economics - The "At What Cost?"
The story is not half in terms of revenue. The unit economics indicates the quality of such revenue. It is the think top-line (revenue) to bottom-line (profit) thinking.
Customer Acquisition Cost (CAC): What sales and marketing expenses are incurred to get a paying customer?
Lifetime Value (LTV): So how many gross dollars do you think you will make out of a customer as long as they remain with you?
The LTV:CAC Ratio: The golden rule. A ratio of more than 3:1 is mostly assumed to be healthy. It informs whether the revenue model is viable or not. In case CAC is more than LTV, the company is losing money to expand.
Contribution Margin: What profit will each extra unit sold contribute to the fixed costs after all the variable costs directly related to the product/service have been subtracted? When the contribution margin is high, this implies that it is a scalable model.
Layer 5: Sales and Distribution Channel: The Path to Market.
What is the actual method of collecting the money? This affects cost, scale and customer relationship.
Direct Sales: High-contact, high-price, high-supervision (e.g. Salesforce enterprise sales).
Indirect/Channel Partners: By resellers, distributors or affiliates. Smaller control but wider reach (e.g. Microsoft software distributed by partners).
Online/D2C (Direct-to-Consumer): Reducing middlemen, typically through a site or an app (Warby Parker, the expanding D2C division of Nike).
Marketplace/Aggregation: The company does not maintain inventory but creates a connection between the buyers and sellers (Amazon Marketplace, Uber).
Integrating It All: Case Study Analysis.
We are going to use this framework with a more recent and complicated company: Amazon.
The Easy (Incorrect) Solution: It is an online store which sells products.
The Analytical Answer:
Central Streams and Models: Amazon has several, different revenue engines:
1. Online Stores (Volume-Based): Retailing in its owned products. Low-margin, high-volume.
2. Third-Party Seller Services (Commission/Transaction-Based): marketplace commission, fulfillment fees (FBA) and shipping fees. This is usually high-margin than its own retail.
3. Amazon Web Services (AWS) (Subscription/Usage-Based): Cloud computing recurring contracts, usually in combination with usage costs. The major profit driver and extremely high-margin.
4. Subscription Services (Recurring): Audible, Kindle Unlimited, and Prime memberships. Sticky, predictable revenue is created.
5. Advertising (Advertising-Based): Video advertisements on Prime. A very high-margin and fast growing stream.
Pricing Power: Dependent on segment. Retail, low (competitive market). A major cause relative to AWS is due to scale, reliability and ecosystem lock-in. In the case of Prime, high due to the value bundling.
Unit Economics: The retail divisions have thin contribution margins, which are exploited to create scale and a huge customer base. The unit economics at AWS and Advertising are excellent. The flywheel effect is important: Prime members are more attracted to retail as it spends more, more sellers are attracted to the marketplace to fund AWS infrastructure, which reduces costs to everyone.
Sales Channel: D2C, mostly online, and marketplace. B2B sales for AWS.
This understanding is subtle and, that is why, analysts are appreciating Amazon not as a straightforward retailer but an assortment of enterprises with diverse economic attributes, headed by a high-margin tech giant (AWS). It explains their business strategies, investment focus and eventual profitability.
The Toolkit of the Analyst: Developing this Skill.
Begin with the 10-K: Direct to the Business part (Item 1) and the management discussion and analysis (MD&A). The business describes itself using a simple language. Then consider the revenue break down in the financial statements.
Track the Customer Journey: Draw out the way an average customer learns about, considers buying, acquires and consumes the product. Where do money and money exchange hands?
Calculate the Key Metrics: Do not read about them. Determine LTV, CAC (where available in disclosures), segmental gross margin and growth percentages on various streams of revenue.
Podcasting Earnings Calls: Pay attention to Q&A. Pay attention when analysts discuss the concept of mix shift, take rate, billings vs. revenue, or unit economics. This language is the revenue model analysis language.
Develop a Revenue Waterfall Model: A basic spreadsheet that disaggregates the total revenue into its streams. Predict streams individually depending on their individual drivers.
Benchmark Competitors: What does the competition make money? Are they using the same model? If not, why? What are the pros or cons brought about by each model?
Recommendation: The Analyst to Strategist.
Getting a grip on the question How does this company make money? is not a one-time exercise. It is an endless process of questioning. With the world of technology changing business models as the perpetual software license turns into SaaS, or the ownership of cars into mobility-as-a-service, the analyst has to revisit and re-evaluate on a regular basis.
This ability makes an analyst more than a reported person because it turns them into a business mind. It enables you to:
Spot red flags (e.g. revenue increasing on the basis of unsustainable discounts only).
Spot opportunities (e.g. a company that has a user base that is loyal but has an under-monetized platform).
More penetrating questions to the management.
Prepare better and stronger financial models.
Finally, come up with an assured investment thesis or strategy - one that is founded on a thorough grasp of economic reality, rather than narrative.
Finally, in a complexity and change-filled world, some of the deepest truths are sometimes found by going back to one of the simplest questions. No other is more fundamental than this. Get it as the fundamental of your analytical art.
Learn Financial Modeling 🚀
Enroll Now🔗 Related: Explore More Finance Guides