Understanding Revenue

Businesses make money… or at least they’re meant to. But do you know exactly where those dolla’ bills are coming from?

So you’ve found a company you’re interested in investing in.

Now what?

First and foremost, you need to get to grips with how that company generates revenue. Revenue is the engine of every business. Without revenue, you have no business to speak of.

Revenue, even in an unprofitable business, is essential to growing a company. Revenue creates cash flows which can go towards research and development, hiring talent, and marketing a product.

So it’s important to understand revenue in more depth than simply knowing what a company sells or what services it provides. However, you should still take a look at this fundamental before you continue on. You’d be surprised how many businesses you thought you understood before you dig a little deeper.

Understanding Revenue

If you were to ask most people how The Coca-Cola Company drives revenue, they would say that they make and sell Coca-Cola.

Actually, what they really do is make the syrup that is then sold to licensed bottlers around the world, who then make the finished product and distribute it to the local merchants. There’s actually a totally separate company called The Coca-Cola Bottling Companies Consolidated, and they’re listed on the stock exchange under the ticker symbol COKE.

Imagine how confusing that is for new investors.

Coca-Cola also owns the rights to over 500 other non-alcoholic beverage brands, including Sprite, Fanta, Minute Maid, Powerade, Schweppes, and Simply. They also have numerous bottled water interests in countries around the world. They own about 16% of Monster Energy, the distribution rights to Dr. Pepper and Snapple in the United States, and much much more.

So as you can see, there’s far more to the Coca-Cola Company than first meets the eye.

Other companies can adapt and change how they generate revenue over the years. Amazon used to sell books over the internet – now they sell everything under the sun. They also have their Amazon Prime subscription service, Amazon Web Services, Amazon Marketplace etc. etc. etc.

TripAdvisor is an interesting example of this. When they first spun-off from Expedia back in 2011, the company’s main source of revenue was click-based advertising and display ads. But management decided in 2014 that they could leverage their massive user base to become a one-stop shop for travelers rather than redirecting them to other sites.

The last two years have seen pretty stagnant growth at TripAdvisor as they’ve rolled out this ‘Instant Booking’ feature. This has essentially seen them move from an advertising-based revenue model to a commission-based revenue model. Only time will tell if this proves to be a successful venture, but this is the kind of information you should be aware of before you start investing in a company.

There are also plenty of different types of revenue model and some are more successful than the other.

Let’s look at three different businesses and see how their revenue models differ.

Starbucks has many forms of revenue, but their biggest one by far is selling cups of coffee. People come into a Starbucks and pay their $5 for a cup. That’s the business relationship over for the time being.

Netflix, on the other hand, sells subscriptions. You pay $10 to watch all the Netflix you want. At the end of the month, you have to decide to cancel. Otherwise, you’ll automatically be charged another $10. This is a subscription model.

Subscription models offer far more stable revenue streams because the customer actually has to take an action to end the business relationship. In the case of Starbucks, the customer has to take an action to continue the business relationship, i.e. going back to Starbucks the next day.

There’s also the razor and blade model, as it’s affectionately known. In this situation, a company sells you something (usually quite cheaply) and then sells you the necessary parts for a high markup. Can you guess where the name comes from?

Gillette will sell you a razor for very little, but the replacement blades will then generate them recurring revenue at a high markup. Keurig Green Mountain and Nespresso have done the same with coffee. Once you’ve bought the machine, you have to shell out for their expensive coffee pods.

This is a great revenue model if you can pull it off. It essentially locks the consumer into a contract that has a relatively high switching cost if they want to get out of it. In order to stop buying the expensive “blades”, you have to give up the razor and find a new supplier.

These just a few examples of the many ways in which different companies make money. What’s important is to understand exactly how the company you are investing in does it. Then you can decide whether you think that’s sustainable, whether it will grow or decline, and whether or not there are any significant risks to their revenue streams.

If you want to find out first hand how a company generates revenue, the best place to look is in their annual reports. All this information will be contained in the very first section, usually titled “Business”.

If you’re not sure how to find annual reports, check out this blog we wrote on the subject.

Happy Investing!

 

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