How Business Models Contribute to the Valuation of Companies

The last few days I have been working with Dr. Vijaya Thyil from La Trobe University in Melbourne, Australia. She is a marvellous and funny Indian intellectual with a very diverse background. She and Prof. Geoffrey Durden have kindly invited me to start a new business model research with them based on a series of qualitative interviews with various companies. This in itself is quite interesting, but today Vijaya and I discussed another exciting area where the business model concept could potentially contribute: financial valuation of companies.

The idea came up while we were driving back from a software demo and were discussing the evening lecture on financial valuation that Vijaya was about to give. Without further ado she invited me to give a short guest lecture on the link between the business model concept and financial valuation at the beginning of her MBA teaching. Though I didn't have a clue what exactly I was going to say I happily accepted because intuitively I felt the connection between the two. And Vijaya and I indeed came up with some good and rather clear ideas during our brief discussion. For example, while the finance industry is very strong in number crunching and has strong methods rooted in (historical) financial data it performs less well on methods that analyze where those numbers actually come from: The business logic - what a company does day-in day-out.

I organized the hour the MBA students and I spent together on discussing business models and financial valuation as a participatory session (or as I called it a "collaborative thinking session based on our collective intelligence"). After briefly touching on the business model concept we came up with the following contributions that financial valuation could get from an increased business model understanding (among other discussed ideas):

  • If we understand the business model of a company better, we get more accurate assumptions on growth estimates and risks. This is an interesting contribution because the financial industry is chronically weak on defining these (despite the "exact" nubmers like 8.9% growth). It mainly relies on historical data, which particularly in the case of young and innovative companies can be problematic.
  • Understanding the business model includes understanding cost structures and revenue streams. This should definitely lead to a better understanding of free cash flow.
  • Understanding the business model better allows to identify who exactly the competitors are. The financial industry still mainly thinks in industry categories while it becomes more and more difficult to put companies into one of these categories (as experienced by the students in their assignments). For example, is Apple in the hardware business (iMac), software business (iTunes, MacOS), consumer electronics (iPod) or retail (iTunes, iShops)? Describing the business model will lead to understanding who the competitors are and in return this will help better define growth and risk
  • ...

In any case I would say we had an interesting discussion and I enjoyed the exchange with the students. Since I took up my nonprofit management job I only had little time for teaching... So it was great fun! And maybe if we had had time to dig a little deeper into this topic we could come up with a better understanding of how, for example, eBay came up with a valuation of $2.6 billion in up-front cash and eBay stock, plus potential performance-based considerations to buy Skype.