The Beauty Of Business Models

Published in Investing on 4 January 2011

A new reporting requirement may help investors.

It has been introduced without fanfare or controversy, but a recent addition to the corporate governance code may prove to be of value to investors.

For company year ends after 29 June 2009, the UK Corporate Governance Code requires companies to describe their business model. Specifically it states that:

"The directors should include in the annual report an explanation of the basis on which the company generates or preserves value over the longer term (the business model) and the strategy for delivering the objectives of the company."

How successfully a company "generates or preserves value over the longer term" should be a pretty good indicator of the performance of its shares, so to my mind this is valuable information for assessing a company -- and an invitation to the company to describe its investment case.

Details

For details of what might be included in the business model description, the governance code refers to the Accounting Standards Board reporting statement on best practice for the Operating and Financial Review. This has been in force since 2006, but its requirements are quite general. 

The punchy obligation of the governance code to explain how the company generates value should hopefully lead companies to better explain their business models.

As well as describing the company's main products, services, customers, processes, structure and facilities, the business model is likely to discuss the company's competitive position within its major markets and the significant features of the legal, regulatory, macro-economic and social environment which influence it.

Good examples

Of course, whatever the reporting requirements, some companies will make more of an effort than others to explain how they create value for shareholders.

Serco's (LSE: SRP) 2009 report provides a good example of a clear and full description of the markets it operates in, its strategy, and how it gains business.

In the REIT sector, Hammerson (LSE: HMSO) is another good example. In addition to a lot of natty diagrams explaining the company's approach (which may or may not be to your taste) the 2009 annual report contains a section which explains typical property lease terms in the UK and France (Hammerson's main markets) and an explanation of why office values fluctuate more than retail.

If you believe as I do that understanding the industry is vital to evaluate a company within it, then it is reassuring to find the company making the effort to explain it.

Operating in a much more complex industry, ARM Holdings (LSE: ARM) goes to some length in its 2009 report to explain its business case, with disarmingly straightforward sections such as:

  • how ARM makes money;
  • why semiconductor companies use ARM technology;
  • technologies that are suitable for the ARM business model; and
  • trends, risks and opportunities.

Financial companies have complexities of their own. Man Group (LSE: EMG) describes its business model on the inside front cover of its 2010 annual report, where it tells readers:

"The overall purpose of this Annual Report is to explain our strategy, discuss our recent performance and illustrate the sustainability of our business model."

Perhaps the main difference between good and bad reporting is between those companies who regard the annual report principally as a communication with shareholders, and those who treat it as a legal and regulatory obligation.

Annual reports

Over recent years reporting requirements have become more onerous with the result that annual reports have got ever longer, and contain more and more boiler-plate language. In consequence investors read them less, or less thoroughly. 

I certainly now skip through annual reports to read the pieces I'm most interested in, but I worry about what is in the pieces I don't read.

Hopefully more companies will now present their business models in a way which truly improves understanding of the investment case. And this section of the business review will be worth having a careful look at.

More from Tony Reading:

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