Understanding a company's business model

What is the first thing to look at when analyzing a company's earnings report?

EPS? Free cash flow? Or ROE?

They are all important financial ratios. However, before digging into these numbers, let's first see if the company is worth spending a lot of time analyzing.

How to know that? The answer is the business model.  A business model is a company's plan on how to make money.

For example, a grocery store makes money by selling a range of food products. Commercial banks make money by providing and earning interest from loans.

There are many ways to make money. Direct selling, franchising, and operating brick-and-mortar stores are some of the traditional business models. There are also hybrid models, such as businesses that combine e-commerce with brick-and-mortar stores.

For investors, it is important to understand a company's business model.

For one thing, understanding business models may help us make smarter investment decisions. Famous value investor Warren Buffett once said he only invests in a business that he fully understands.

For another, understanding the business model helps read financial data. For example, different businesses could have different profit margins, which are key performance indicators. Tech companies like Microsoft generally have higher profit margins than retailers such as Walmart. However, it doesn't mean Microsoft is more successful than Walmart.

Suppose you want to gain more insights into a company's business model.

What would you do?

here are two things to look at in a company's annual report that help investors better understand how the company operates.

They are item 1, "Business", and item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations".

These two give a full description of the company's business, including its main products and services and which markets it operates in.

Let's take Apple as an example.

By reading item 1, we know that Apple is a company that makes money by selling hardware and services. Hardware includes iPhone, Mac, iPad, AirPods, and Apple TV. Services include advertising, cloud services, digital content, and payment services, to name a few.

In item 7, Apple breaks down its revenue by segment and category， allowing investors to know the exact performance of products and services and segment operations.

In addition, item 1 and item 7 also provide information on the company's recent events and the competition it faces to help investors better understand its business.

Once you've learned how the company aims to make money, you might want to consider researching the company further.

If you are not interested in the company's business, consider choosing another company to analyze. If you feel that the company has growth potential, you may continue to dig into the company's financials.

The best place to study a company's financial position is the three major statements: income statement, balance sheet, and cash flow statement.

In the following video, we will start with the income statement.