The earnings model is the engine of a company. When you understand the earnings model, you understand how the engine works, i.e. how the company makes money.
This is why we speak about earnings models with the same passion that we apply to finding companies with excellent earnings models.
We invest in earnings models, not in stock prices. What do we mean by this?
“The earnings model is the structure on which a company executes its strategy. The strategies of companies are often described in rather lofty ways, but the earnings model — or more broadly, the business model — tells us whether superiority can be achieved,” says Hannes Kulvik, Founder of Sifter.
“A good company is superior to its competitors in creating value for its customers and itself.”
In our view, the hallmarks of a good earnings model are:
Predictability creates security. We must be able to identify what the company’s earnings model is and what potential it has for development.
For example, companies whose business mostly consists of individual projects are less predictable than companies whose business is based on continuous services.
2. Sustainability and differentiation
Earnings models must be sustainable and differentiated from the competition. If the earnings model is easy to break, the company is exposed to constant competition.
The sustainability of the earnings model can be evaluated on the basis of how important the product is to the customer and how well it is protected from the actions of competitors. Differentiated earnings model is more difficult to replicate by competitors.
3. Growing capacity to make money
A good sign of a earnings model is when it can continuously improve the company’s earnings growth.
When we evaluate a company’s earnings model, we examine its competitive advantage on two levels: firstly, what competitive advantage does the company have in producing customer value, and secondly, what competitive advantage does the company have in creating shareholder value.
Being able to charge a premium price for products is not enough in itself. The company must be able to produce its products and services efficiently enough to continuously grow the bottom line. This comes down to the company’s operational efficiency, culture, leadership, and financing structure.
The best earnings models are those built on continuous — and preferably growing — business between the company and its customers.
This is achieved when the company’s product or service creates more value for the customer than the solutions offered by its competitors. This also gives the company high pricing power.
Examples of strong earnings models
The compressors and vacuum pumps of the Swedish company Atlas Copco are a good example. While they represent only a small proportion of the overall costs of the customer’s production facility, their quality and reliability is critical for the manufacturing process. This naturally calls for continuous servicing and maintenance.
As the requirements for products such as semiconductors and microchips become increasingly complex, there is growing demand for even better vacuum pumps for use in manufacturing processes as well as the servicing and maintenance that they require.
Many engineering companies that previously supplied their customers with individual products have changed their earnings model to sell comprehensive service agreements in addition to the machines themselves.
In fact, the long-term service agreements are where they earn their margins.
Another type of earnings model that is highly attractive is a model based on continuous subscriptions and annual fees.
The U.S. company Verisign operates partially as a monopoly and maintains domain name services for corporate websites in domains such as .com and .net. It has hundreds of millions of customers and the demand for its services grows steadily from one year to the next.
Shutting down a website is something that few companies will ever do, even in significant economic downturns.
Saying that we prefer to invest in earnings models rather than stocks may sound like semantics, but the statement reveals a fundamental difference in thinking. Among other things, this difference is reflected in the time horizon that the investor is prepared to take.
When you know that a company has a high-quality earnings model, investing in the company is sensible as long as you can buy its shares at a reasonable price.
“Investing in good earnings models gives the investor peace of mind.”
“Looking at share prices and guessing where they might go next will only make you nervous,” Hannes Kulvik concludes.