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Dear Dagen: Business Models Explained

Every business has one. The key is figuring out which company has the better one.

What do writers and analysts mean when they say that the model for a particular company is good? Are they referring to the business model? How would the average person go about finding the model for a particular business? -- Shelley Martinez

Shelley,

A business model is an all-encompassing strategic plan that details how a company intends to conduct and grow its business. These strategies can vary wildly, even within the same industry. Your ability as an investor to figure out what makes a good business plan will help you discern which company will succeed and which will become the next

Boston Chicken

(BOSTQ)

.

A typical business model begins with management's sweeping vision of the industry in which it operates and of its future. This plan will sketch the company's existing and future product lines or businesses, whether they're bicycles or burgers. It also will detail the various markets in which it is doing business, markets it plans to enter, its target customers and how the company is distributing its products. Simply, you should get a good idea of how the management is running the company.

If a company is newly public, the registration for its initial public offering is a good place to get a read on its business model. Here's some of what

Neuberger Berman

has to say in its IPO filing:

The firm's principal businesses include private asset management and mutual fund and institutional money management. The company's revenue primarily comes from fees and commissions based on its assets under management. And more than 75% of the firm's assets under management are held in equity accounts, which carry higher fees than fixed-income accounts.

The filing also explores the firm's growth strategy by adding to its national sales force, for example.

A company's sales approach can be one key element that might differentiate its business model from another. For example, a company has a product to sell, and it will typically pick one of two ways to sell it to its customers: directly or indirectly. Direct sales involve selling goods straight to the customer through a company's own retail stores, for example. Indirect sales involve selling goods through an intermediary.

When a company is selling low-priced items, say some software applications, the better business model is usually indirect sales, says David Kern, manager of the

(FUSSX)

Fremont U.S. Small-Cap fund. With lower-priced items, a company might need a huge sales force in order to reach optimum revenue numbers. And "it costs a fortune to staff a direct sales force," he explains.

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On the other hand, higher-priced products, such as mainframe computers, lend themselves to direct sales, Kern adds. Because these items cost so much to make, it can be economical to bring on an appropriate number of salespeople. Plus, these products can be much more complex than, say, a piece of software and can require greater support from the company.

Even within the same industry, the business models of companies can be dramatically different. Bill Nygren, manager of the

(OAKLX) - Get Oakmark Select Investor Report

Oakmark Select fund, illustrates this point with two holdings from his portfolio: apparel companies

Gucci

(GUC)

and

Liz Claiborne

(LIZ)

.

Gucci's business model "is to sell to a very narrow group of customers but to sell very high-profit products to that group," Nygren says. Think of big-ticket bags, belts and fashions designed by Tom Ford. Liz Claiborne, on the other hand, appeals to the mass market and a much broader group of customers. Picture apparel for the everywoman. These two companies have created two dramatically different target markets and are selling their goods at different price points, Nygren adds.

You can get the best illustration of a company's business model by reading its annual and quarterly reports. In a company's annual report, start by reading the shareholder letter in the front and work your way through the report's footnotes at the rear.

The letter to shareholders from the CEO can tip you off to any changes in strategy or areas of emphasis for the coming year. In the letter to

Nike

(NKE) - Get NIKE, Inc. Class B Report

shareholders in the company's 1999 annual report, for example, Chairman Philip Knight has this to say about the Internet:

While there is plenty of controversy swirling around this new medium, we absolutely believe it is creating an entire business revolution, and we truly intend to be a part of that revolution. If we had a clear-cut strategy I would not reveal it publicly, but ours is a strategy, that, in a word from that world, is iterating. You can get your best understanding of that by watching our Web pages. I believe you will see a lot of action in the next 12 months.

OK, this doesn't reveal too much, but it gives you an idea that it is a growing part of the company's strategy.

These days you can find the annual reports of many companies on their respective Web sites. But you may want to call the company and get the glossy, printed version of its annual report mailed to you. It's certainly more fun to read.

My explanation of a business model might seem obvious. But understanding a company's strategy and the qualitative details of its business may be more important than a lot of the financial minutiae that gets written up these days.

Companies are living and breathing businesses as much as they are balance sheets and income statements.

Once you've figured out where the company wants to go with its business, you'll need to make your own judgment about whether it's a good strategy. You also need to know whether the company is achieving its goals; that's where you start moving into fundamental analysis. For more information on how to read and analyze a company's fundamentals, read

TheStreet.com's

Basics of Fundamental Analysis.

Send your questions and comments to

deardagen@thestreet.com, and please include your full name.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.