Gennaro Cuofano's Blog, page 255

McDonald’s Heavy Franchised Business Model In A Nutshell

 

McDonald's can be defined as a heavy franchised business model company. In fact, as of 2017 of its total restaurants, 92% were franchised. The long-term goal of the company is to achieve 95% of franchised restaurants. This model has allowed McDonald's to grow its net income from $4.5 billion in 2015 to $5.2 in 2017. The heavy franchised business model enables McDonald's to have higher gross margins and operating income while rent and royalty income received from franchisees provide a more predictable and stable revenue stream with significantly lower operating costs and risks.

McDonald's origin story: from the McDonald Brothers to Mr. Ray Kroc

As explained on McDonald's website "Dick and Mac McDonald moved to California to seek opportunities they felt unavailable in New England." In 1948 they launched Speedee Service System featuring 15 cent hamburgers. As the restaurants gained traction that led the brothers to begin franchising their concept until they reached nine operating restaurants.

A native Chicagoan, Ray Kroc, in 1939 was the exclusive distributor of a milkshake mixing machine, called Multimixer. In short, he was a salesman.

He visited the McDonald brothers in 1954 and was impressed to their business model which led to him becoming their franchise agent. He opened up the first restaurant for McDonald’s System, Inc., until in 1961 he acquired McDonald’s rights to the brother’s company for $2.7 million.

Ray Kroc, died on January 1,4 1984, all the rest is a legend.

Is McDonald's a franchising? You bet, and a heavy one!

Of the 37,241 restaurants in 120 countries at year-end 2017, 34,108 were franchised, and the Company operated 3,133 restaurants.

This makes the company 92%.

As specified in its 2017 annual report "McDonald's is primarily a franchisor and believes franchising is paramount to delivering great-tasting food, locally-relevant customer experiences and driving profitability. Franchising enables an individual to be his or her own employer and maintain control over all employment-related matters, marketing, and pricing decisions, while also benefiting from the financial strength and global experience of McDonald's. However, directly operating restaurants is important to being a credible franchisor and provides Company personnel with restaurant operations experience."

McDonald's goal is to have approximately 95% franchised over the long-term. That makes of McDonald's a heavy franchised business operation.

How do McDonald's partnerships work?

As specified in its annual report "under McDonald's conventional franchise arrangement, franchisees provide a portion of the capital required by initially investing in the equipment, signs, seating, and décor of their restaurant business, and by reinvesting in the business over time. The Company generally owns the land and building or secures long-term leases for both Company-operated and conventional franchised restaurant sites. This maintains long-term occupancy rights, helps control related costs and assists in alignment with franchisees enabling restaurant performance levels that are among the highest in the industry."

In short, the model is pretty smart. McDonald's keeps control over the land and or long-term leases to leverage its market position to negotiate deals. At the same time, this kind of deal serves as an alignment between the company and its franchisees.

What are McDonald's segments?

At the qualitative level the segments can be organized in four main ones:

The U.S., which as of 2017 represents still the most significant market
International Lead Markets include Australia, Canada, France, Germany, the U.K. and related markets.
High Growth Markets which comprise markets with high growth potentials include China, Italy, Korea, the Netherlands, Poland, Russia, Spain, Switzerland and related markets.
Foundational Markets & Corporate, the remaining markets in the McDonald's system, most of which operate under a primarily franchised model.

As of 2017, the U.S., International Lead Markets, and High Growth Markets accounted for 35%, 32% and 24% of total revenues, respectively.

Who are McDonald's key partners?

McDonald's business model is based on three key players. Franchisees, suppliers, and employees are the piece of the puzzle of McDonald's successful business model.

Franchisees are entrepreneurs that at local level allow McDonald's to expand rapidly while keeping a global focus
Suppliers across the globe guarantee McDonald's the ability to operate at a high level
The continuous training of employees across the over thirty-six thousand restaurants around the world allow McDonald's to perform at full speed

What management metrics McDonald's uses to asses its growth?

Any organization has a set of management ratios and metrics to understand and assess the growth of the business.

McDonald's looks at the following metrics:

Comparable sales and comparable guest counts: the percent change in sales and transactions, respectively, from the same period in the prior year for all restaurants, whether operated by the Company or franchisees, in operation at least thirteen months, including those temporarily closed
ROIIC: calculated by dividing the change in operating income plus depreciation and amortization (numerator) by the cash used for investing activities (denominator), primarily capital expenditures
Free cash flow: defined as cash provided by operations minus the capital expenditures 
Free cash flow conversion rate: defined as free cash flow divided by net income, are measures reviewed by management to evaluate the Company’s ability to convert net profits into cash resources

McDonald's velocity growth plan in action

McDonald's has launched and developed a velocity growth plan based on three pillars:

Retain the customers they have
Regain the customers lost by improving the taste and quality of food, enhancing convenience and offering strong value
Convert casual customers to more committed customers with coffee and snacks

They also identified three accelerators, intended to drive growth:

Digital by re-shaping interactions with customers
Delivery by bringing the McDonald’s experience in their homes
Experience of the Future in the U.S. which consist of a set of new technologies within the restaurants to enhance the efficiency and improve the experience

Why is McDonalds' transitioning to a heavy franchised business model?

The transition to a more heavily franchised business model is part of the long-term company's strategy. In fact, as the rent and royalty income received from franchisees provides a more predictable and stable revenue stream with significantly lower operating costs and risks.

In a way, it is almost like McDonald's is introducing a subscription business model, where franchisees pay a fixed amount each month. That makes McDonald's income more stable over time.

Also, the operating and net income coming from franchising operations makes it easier for the company to grow its profitability.

Key takeaways and summary infographic of McDonald's heavy franchised business model

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McDonald's uses a heavy franchised business model. In fact, as of 2017, the company has 92% of total restaurants as franchising. Its long-term target is 95% of franchised restaurants worldwide.

Even though revenues have decreased from $28 billion in 2013, compared to $22.8 billion in 2017, the gross margins have increased. Also, the net income increased from $4.5 billion in 2015 to $5.2 in 2017.

That is mainly due to the change in business model skewed toward franchised restaurants.

Although company-operated restaurants have higher revenues compared to franchised restaurants, they contribute less to the company's gross margins and net income.

That happens because the net revenues for the franchised restaurants take into account the royalties reported by those, rather than the net sales. In addition, rent and royalty income received from franchisees provide a more predictable and stable revenue stream with significantly lower operating costs and risks.

Other handpicked case studies:

What Is the Receivables Turnover Ratio? How Amazon Receivables Management Helps Its Explosive Growth
Amazon Case Study: Why from Product to Subscription You Need to “Swallow the Fish”
What Is Cash Conversion Cycle? Amazon Cash Machine Business Model Explained
How Amazon Makes Money: Amazon Business Model in a Nutshell
The Power of Google Business Model in a Nutshell
Starbucks Business Model In A Nutshell

The post McDonald’s Heavy Franchised Business Model In A Nutshell appeared first on FourWeekMBA.

Starbucks Business Model In A Nutshell

 
Starbucks is a coffee retail company that sells beverages (primarily consisting of coffee related drinks) and food. Even though Starbucks has 49% of company-operated stores vs. 51% of licensed stores, revenues for company-operated stores accounted for 79% of total revenues compared to just 11% of licensed stores in 2017. Thus even though licensed stores generally have a higher operating margin than company-operated stores, the company can be defined as a company owned business model.

Starbucks origin story

It was the year 1983, Howard was a young man, walking through the streets of Milan and Verona. As Howard Schultz would put it, he became "enamored" by the coffee experience people had in the Italians bars. 

Places where the Barista knew the name of each person entering it and the coffee experience was about more than just a cup of coffee, it was about creating this sense of community. That's how Howard Schultz set to bring that same experience back in the US.

At that time, in 1983, Starbucks had three stores in Seattle. However, it wasn't serving any beverage, but only coffee to bring home. When Howard looked at the way Italian experienced coffee, he understood the real segment of the business that could have made Starbucks truly successful was serving coffee directly to consumers.

The objective was to replicate the Italian experience back in the US. Thus, making Starbucks - in the words of its founder - the third place between work and home.

What's Starbucks mission?

As specified in its annual report its mission is to provide the so-called Starbucks Experience, consisting in "superior customer service and a seamless digital experience as well as clean and well-maintained stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty."

What are the primary segments of the business?

The main Starbucks segments can be broken down in:

Company-operated Store Revenues
Licensed Store Revenues
CPG, Foodservice and Other Revenues

At geographical level instead Starbucks operates in four main regions:

Americas, comprising US, Canada, and Latin America
CAP, comprising China/ Asia Pacific
EMEA, comprising Europe, Middle East, and Africa
All others, which is related instead to the development of new products, thus called "channel development"and "includes roasted whole bean and ground coffees, premium Tazo® teas, Starbucks- and Tazo-branded single-serve products, a variety of ready-to-drink beverages, such as Frappuccino®, Starbucks Doubleshot® and Starbucks Refreshers® beverages and other branded products sold worldwide through channels such as grocery stores, warehouse clubs, specialty retailers, convenience stores and U.S. foodservice accounts"

Is Starbucks a chain or franchising?

If we look at the mix of operated vs. licensed stores, the answer is both. However, if we look at the revenue generation, company-operated stores make up 79% of the company's revenues in 2017.

As specified on Starbucks annual report for 2017, "The mix of company-operated versus licensed stores in a given market will vary based on several factors, including our ability to access desirable local retail space, the complexity and expected ultimate size of the market for Starbucks and our ability to leverage the support infrastructure within a geographic region."

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While Starbucks has over fourteen thousand licensed stores, compared to over thirteen thousand company-operated stores, most revenues come from the former.

Where do most of Starbucks revenues come from?

As of 2017 company-operated stores accounted for 79% of total net revenues. Instead, 11% is produced by the licensed stores, which have lower gross margin and a higher operating margin than company-operated stores.

As specified in the Starbucks annual report for 2017, "In our licensed store operations, we leverage the expertise of our local partners and share our operating and store development experience. Licensees provide improved and at times the only, access to desirable retail space."

It is important to remark that even though company-operated stores have higher gross margins. They also have a lower operating margin compared to licensed stores.

What are the most sold Starbucks products?

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As specified in its 2017 annual report "Starbucks is committed to selling the finest whole bean coffees and coffee beverages. To ensure compliance with our rigorous coffee standards, we control coffee purchasing, roasting and packaging and the global distribution of coffee used in our operations. We purchase green coffee beans from multiple coffee-producing regions around the world, and custom roasts them to our exacting standards for our many blends and single origin coffees."

In terms of revenue generation beverages represented 73% of the net sales in 2017.

How does Starbucks protect itself from the sudden change in the price of raw coffee?

As specified in the 2017 annual report Starbucks" buys coffee using fixed-price and price-to-be-fixed purchase commitments, depending on market conditions, to secure an adequate supply of quality green coffee. Price-to-be-fixed contracts are purchase commitments whereby the quality, quantity, delivery period, and other negotiated terms are agreed upon, but the date, and therefore the price, at which the base “C” coffee commodity price component will be fixed has not yet been established. For most contracts, either Starbucks or the seller has the option to “fix” the base “C” coffee commodity price prior to the delivery date. For other contracts, Starbucks and the seller may agree upon pricing parameters determined by the base “C” coffee commodity price. Until prices are fixed, we estimate the total cost of these purchase commitments. Total green coffee purchase commitments as of October 1, 2017, were $1.2 billion, comprised of $860 million under fixed-price contracts and an estimated $336 million under price-to-be-fixed contracts."

How much revenues does Starbucks make?

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The total revenues in 2017 surpassed the $22 billion compared to $14 billion in 2013. 79% of net sales came from company-operated stores.

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If we look t the change in revenues of 2017 over 2016, company-operated stores grew by 4.8% while licensed stores grew by 2.7%.

Summary and conclusions

Starbucks is a coffee retail company that was inspired by a trip by Howard Schultz in Italy. When in the Bars in Milan and Verona he saw the whole experience of having coffee, he realized it was way more about building communities around local coffee shops, rather than just coffee itself.

That's how he thought to rebuild and bring the same kind of experience back to the US. Ever since Starbucks has been a global success. It also announced its first store in Milan, after decades. That represented a milestone for the company.

At the financial level Starbucks has 49% of company-operated stores (in 2017) compared to 51% of licensed stores. It is important to remark that also the licensed stores are more of partnerships between Starbucks and local entrepreneurs with years of experience.

Even though the model might be that of franchising, those partnerships are selected to guarantee the growth of the Starbucks brand around the world. In fact, Starbucks is among the most recognized brand names in the world.

Other hand-picked case studies: 

What Is the Receivables Turnover Ratio? How Amazon Receivables Management Helps Its Explosive Growth
Amazon Case Study: Why from Product to Subscription You Need to “Swallow the Fish”
What Is Cash Conversion Cycle? Amazon Cash Machine Business Model Explained
How Amazon Makes Money: Amazon Business Model in a Nutshell
The Power of Google Business Model in a Nutshell

The post Starbucks Business Model In A Nutshell appeared first on FourWeekMBA.

The Five Key Factors That Lead To Successful Tech Startups

 

Launching a successful tech startup is a complex endeavor that depends upon many and many factors. Some are internal and can be controlled.

Think of the quality of the product, the innovation, or the relentless customer focus. Some others are external, thus cannot be controlled.

Think about timing, the success of a complementary technology that allows yours to thrive and so on. In this article, I want to focus on five factors that Bill Gross, founder of Idealab and GoTo (afterward named Overture) identified.

It is important to remark this analysis is not "scientific" in the strict sense as Bill Gross applied subjective parameters to each factor in consideration. However, overall I think it is a good starting point to understand what makes a tech startup successful.

More precisely Bill Gross identified five factors that are critical for any startup success:

ideas
team
business model
funding
timing

We'll be tackling them from the most important to the least important according to Bill Gross.

Number One: Timing

We all know that being at the right place and the right moment is critical. That is even more so in technology. As new technology becomes part of the innovation landscape, their success depends upon how they the ability of those technologies to be understood by a broad audience, to be necessary for other businesses grow and to be ready to be adopted.

For instance, when Google finally developed a search engine that would be able to give relevant results the time seemed to be right. Before that, the Internet was made primarily of web portals, that didn't understand, neither had the interest to follow a different model.

However, in that period the same portals, like Yahoo and AOL understood the importance of offering differentiated traffic.

In other words, for the first time at the end of the 1990s and the beginning of the 2000s, the Internet was transitioning from pure traffic generation to qualified traffic generation. That's where an innovative tool like Google came in handy.

In other cases, when you push too early on a technology that is not ready yet, as other complementing technologies are not powerful enough you might be doomed to failure.

For instance, Bill Gross, the founder of Overture, back in the 1990s was already looking to an alternative search engine that would be based on natural language.

This was undoubtedly innovative, and it was something that people would have liked. However, the timing might have been too early. As semantic technologies were not mature enough to be the main component of search, the whole endeavor became unfeasible.

How do you assess if the timing is right? Although there is no easy way, you can look around and see whether complementary technologies are mature enough.

Take the case in which you have a product, like a video service, which makes it possible for anyone to watch in streaming your content. As that video service runs on a particular technology for which there is not yet accepted standard, millions of users might be not able to use your content.

That tells you that you're too early. How do you handle that? You can either push to reach as fast as possible the right timing (think of when Google, together with other commercial search engines developed Schema.org as an attempt to bring semantic search to its core algorithm, today Schema is a critical part of that).

Or you need to have allocated the resources to survive long enough for when the timing is right. Thus, you need to make sure to plan ahead, and understand what's your burn rate to avoid going out of business too early.

Number Two: Team/Execution

As Bill Gross puts it, one of the reasons he founded Idealab, and he called it this way is because he was convinced that ideas were the most crucial aspect of building a successful tech startup.

However, throughout the years he changes his mind. By going through several successes and way more failures, he figured that ideas only came after the team of people chosen to execute it.

That connects us to the next point.

Number Three: Ideas

Often you hear people scared of telling you their ideas as you might steal them. But as Bill Gross remarked as soon as you start implementing those ideas the real world "punches you in the face." Some ideas turn out to be successful, right away. But those are gems.

For instance, when Bill Gross came out with his search engine, GoTo, he also thought about a - at the time - revolutionary business model, that of pay per click.

That idea at the time seemed extremely crazy. Before Bill Gross could prove it, it took him a team of people to execute it, and he had to spend months on the road divulgating that idea.

Only when the concept was proved, and that idea turned out to be a business model making millions of dollars in profits, Google took notice.

Number Four: Business Models

Bill Gross ranks the business model as the fourth factor among the five most important factors for a tech startup to succeed. The reason is simple.

Startups can initially go about even without a business model. If you take the example of a few startups (Google comprised), those initially didn't have a monetization strategy at all. And Google's founders were pretty reluctant about advertising.

Those companies were focused on technology, product and build up a users base, quickly. Although I agree that the business model isn't necessarily something you need to have for initial success.

In fact, during the first phase making sure you have the best product and technology is critical. Also, usually investors' money will allow the company to survive for a few years before understanding what's the right business model.

However, it is essential to remark that there is a moment in the life of any startup where coming up with the right business model makes the difference between life and death.

For instance, when Google understood that the pay per click model was viable, had it ignored that fact, most probably GoTo would have gained significant traction. Thus, dwarfing Google itself.

That's why Larry Page pushed so much on the AOL deal. There are specific moments in the life of a startup where the focus needs to be a hundred percent on the business side. At that moment business modeling becomes the only critical factor.

Number Five: Funding

Funding is a critical factor for any startup success, yet not the number one. If you have the right timing, team, idea, business model you can grow your business organically. In fact, in many cases funding, if too early can be detrimental for the growth of the startup.

If you inject too much money too early into an organization, you might be making grow it artificially. Organic growth often is the best way to select who deserves to survive. If the above factors are in place, funding is always an option.

Summary and conclusions

As we've seen Bill Gross has identified five factors, comprising ideas, team, business model, funding, and timing. He placed timing, team, and ideas on the top three.

Factors like timing largely depend on luck. That's why making sure to monitor the startup burn rate (how long your startup can survive with the funds it has available) is critical.

On the other hand, the business model and funding are the last two, as Bill Gross argues that a startup can initially thrive if it misses one of the two.

We have to remark that those two factors seem to be mutually exclusive. In other words, if you miss a viable business model, you might want to look for funding so your startup can keep building a great product while experimenting with several business models.

On the other hand, if you do have a viable business model, then the best way to test its sustainability is organic growth. Therefore, you might not need funding for that.

While I agree with Bill Gross' factors and how he ranked them. I want to emphasize that in the life of any startup there is a moment in which choosing the right business model is critical. In that specific window, business modeling becomes the only factor!

The post The Five Key Factors That Lead To Successful Tech Startups appeared first on FourWeekMBA.

Looking For Hollywood? You Need To Be Heading North To The Silicon Valley

 

"When we win a Golden Globe, it helps us sell more shoes," said Jeff Bezos at the Vox's Code Conference back in 2016. This single statement might not make sense at first, yet it thoroughly explains the current battle to keep millions of credit cards linked to their subscriptions, be it Amazon, Netflix, Apple or YouTube. The fight for who's going to conquer Hollywood has already started, and it might soon have a winner. 

This isn't the story of companies like Warner Bros. started out as entertainment companies. This is the story of tech companies, started out as bookstores, expanded in shoe e-commerce, to target the Golden Globe. And that has anything to do with glory and fame, but it has all to do with growth and revenues. 

When I refer to Silicon Valley in this article, I'm not talking about a geographical location but rather a mindset and a way of thinking about entrepreneurship that is all but conventional.

How did it all start? 

The Golden Globe, Amazon Prime, and Jeff Bezos celebrating by checking up the increased sales of the shoe shop 

When Rachel Brosnahan won 2018’s Best Actress Golden Globe for Amazon’s The Marvelous Mrs. Maisel, Jeff Bezos might have been celebrating in a way you would not expect. Not with a bottle of Champagne, neither with fine food. He most probably was checking his store revenues.

As he remarked at Vox's Code Conference in 2016 and as reported on Business Insider, "We get to monetize [our subscription video] in a very unusual way, when we win a Golden Globe, it helps us sell more shoes. And it does that in a very direct way. Because if you look at Prime members, they buy more on Amazon than non-Prime members, and one of the reasons they do that is once they pay their annual fee, they're looking around to see, 'How can I get more value out of the program?' And so they look across more categories — they shop more. A lot of their behaviors change in ways that are very attractive to us as a business. And the customers utilize more of our services."

Amazon's business strategy, which can be defined as a cash machine is based on having narrow profit margins while taking advantage of the so-called cash conversion cycle. That might sound like a financial trick, but it's not. Mastering the cash conversion cycle means, first of all, build a super efficient business, with trusted suppliers and a strong brand recognized by its customers. None of those three things is a growth hack and all three together required Amazon decades to build. Yet as of today this kind of strategy is paying back many times over in business growth.

If we look at the net sales of the group they went from $74 billion in 2013 to over $177 in 2017. If that is not enough, the net profit margin went from 0,3% in 2013, to 1,7% in 2017. That's an astonishing growth (more than 5x) for a company that runs at narrow margins to finance its growth and kill its competition.

However, there is another statistic we want to look at to have a better idea of what's going on with Amazon growth: that's Amazon investment in the production business.

When segments become products line: how Amazon broke down the silos to run an integrated growth strategy

In the old world of massive and bureaucratic corporations, the company gets divided into distinct segments. Those segments are siloed. Therefore there is no integration, communication, neither understanding between one business unit and the other. While I'm sure by becoming a multi-billion dollar company Amazon has also become bureaucratic and way slower than it could have been as a startup. It is undeniable that at higher level Amazon understands the importance of running business segments like those are products offered to the same customers. As shown in the case of Amazon trying to compete for the Golden Globe, the company leverages in its premium members to provide them with "more services" that in reality become more sales for its online store.

This is how Amazon specified in its 2017 annual financial report the production efforts:

award-winning Prime Originals to the service, like The Marvelous Mrs. Maisel, winner of two Critics’ Choice Awards and two Golden Globes, and the Oscar-nominated movie The Big Sick. We’ve expanded our slate of programming across the globe, launching new seasons of Bosch and Sneaky Pete from the U.S., The Grand Tour from the U.K., and You Are Wanted from Germany, while adding new Sentosha shows from Japan, along with Breathe and the award-winning Inside Edge from India. Also this year, we expanded our Prime Channels offerings, adding CBS All Access in the U.S. and launching Channels in the U.K. and Germany. We debuted NFL Thursday Night Football on Prime Video, with more than 18 million total viewers over 11 games. In 2017, Prime Video Direct secured subscription video rights for more than 3,000 feature films and committed over $18 million in royalties to independent filmmakers and other rights holders. Looking forward, we’re also excited about our upcoming Prime Original series pipeline, which

includesTom Clancy’s Jack Ryan starring John Krasinski; King Lear, starring Anthony Hopkins and Emma Thompson; The Romanoffs, executive produced by Matt Weiner; Carnival Row starring Orlando Bloom and Cara Delevingne; Good Omens starring Jon Hamm; and Homecoming, executive produced by Sam Esmail and starring Julia Roberts in her first television series. We acquired the global television rights for a multi-season production of The Lord of the Rings, as well as Cortés, a miniseries based on the epic saga of Hernán Cortés from executive producer Steven Spielberg, starring Javier Bardem, and we look forward to beginning work on those shows this year.

While we don't know exactly how much Amazon Prime brings in revenues (the revenues are spread across product and service sales, and the costs get allocated in cost of sales), we can assume Amazon Prime has become a critical asset in Amazon overall business strategy.

The Netflix dilemma: How multiple streams of income make it easier for Amazon to leverage its premium memberships

When we think of a successful membership service that has been able to launch a popular TV series, undoubtedly that first thought goes to Netflix. However, the Netflix business model is skewed toward the so-called subscription business model. This business model is pretty simple; you pay a fixed amount each month in exchange for a service that is usually ads free.

While this model works and it has helped many companies to gain traction. It is also capital intensive. For Netflix to increase subscriptions and retention, it has to continuously invest billions in production costs, to bring back as many eyeballs on its platform. While this model is sustainable when a company keeps growing and keeps getting outside investments, it might also lead to sudden losses if growth stalls and retention worsen.

In this respect, the Amazon business model might be more robust, and it might give it more freedom to experiment with the Prime Memberships to see how it fits into its overall business strategy. Lately, Netflix itself has been experimenting with advertising its Netflix originals to a small audience as reported on Tech Crunch.

Although this was only a small test for a small percentage of members and mainly focused on promoting Netflix content, it was perceived badly by the few who saw it. That might make the Netflix business model more fragile.

There are drawbacks to a business built solely on a subscription business model

Companies like Netflix have been able to construct a recognized brand around the world with a simple subscription-based business model. This model works for several reasons. It guarantees predictable income (each month, unless something disastrous you start from the same revenues baseline). Customers trust (the subscription business model pushes the company to build long-term relationships with customers). And it requires a lower sales and marketing effort - in theory (as you don't need to start over again to gain the same level of revenues you had the previous year).

It also has some critical drawback to take into account, especially for a business built solely on this model. First, as in most cases unsubscribing from that program is frictionless, the risk of a high churn is real and incumbent. Second, maintaining a stable customer base might be capital intensive as you need to create always new content to make those customers come back and to attract new ones. Third, as competition will grow, it will be harder to keep the member's baseline intact. Just like Amazon is starting to invest billions in producing shows for its Prime Originals, new entrants are coming.

Who'll take over Hollywood?

What I find compelling about how new tech companies approach business strategy is the relentless focus on looking at customers to understand their needs independently from the logic of business segments or traditional corporate thinking. Amazon example on how it's investing in producing TV series to leverage on its Prime Members tells us that those same tech giants are ready to take over any industry if that helps their growth.

Thus, if we could think Hollywood would be safe from Silicon Valley hostile take over, we got it wrong. The same tech industry has been built as much on people's imagination as on financial metrics. While in the past Hollywood production companies were the ones making movies about Silicon Valley; the opposite will be true. In the future. Silicon Valley companies will be making TV series about Hollywood. This is the epic battle to conquer billions of eyeballs worldwide.

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The Deal That Made Google The Tech Giant We Know Today

 

May 1st, 2002, AOL at the time known as America Online announced a deal with Google. That deal was crucial and one of those that made Google the tech giant it is today. Would Google had lost that deal chances are it would have never become the monopolist we know today.

With the AOL deal, Google managed to gain further traction and also kill its main competitor at the time, Overture. Also, that deal was critical as it gave Google the exposure needed to get to its IPO.

In this article, I want to focus on that single deal. Why? In the tech industry, we all like to think that competence, better technologies, and smart engineers are what matter. However, there is another aspect which is critical and - I argue - the most important. The ability to leverage in distribution strategies that allow scalability in terms of service and profits. With the AOL deal, Google got the traction he needed to gain a competitive edge for years to come.

Overture was the father of pay per click advertising

By the end of the 1990s Bill Gross, founder of Idealab, an incubator where he could execute all his ideas, had also founded GoTo a search engine that for the first time used the pay per click business model. In other words, while in the past web portals, like AOL or Yahoo just sent undifferentiated traffic to websites. GoTo introduced a different logic. That of getting paid by the business advertising only when users clicked through it. Thus, only when there was relevant traffic.

The logic behind the GoTo business model might seem trivial today, but it was revolutionary at the time. In fact, with his pay per click Bill Gross would buy undifferentiated traffic from web portals at a low cost and sell that traffic for a much higher price.

GoTo soon changed the name to become Overture; while GoTo was both a search engine and an advertising network. Overture instead became merely an advertising network able to arbitrage on the price difference between undifferentiated traffic and qualified traffic. Thus, Overture was the first to invent and to prove the fact that the pay per click would be the business model of the internet.

At the time AOL was among the most prominent web portals, and among the most significant deals Overture had closed for its distribution strategy. At the time although Google was growing at super fast speed, it wasn't any closer to being the market dominator it would become soon.

Google copied Overture business model and stole the AOL deal

By 2002 Google had finally launched its Google AdWords network that replicated that pay per click business model, and it improved on it. While it also figured out that if he wanted to scale up fast, it had to close large deals with web portals like AOL. Although nowadays AOL doesn't sound to have any importance.

At the time it was among the most popular portals on the web. Known as America Online in 1998 it purchased Netscape, the dominant browser of that time. In short, there was a time when AOL was almost synonym with the Internet. 

In may 2002 the deal between AOL and Overture was expiring, and it was time for Google to take swift actions. As reported in the book "Googled: The End of the World As We Know It" at the time Page said in relation to the AOL deal "I want us to bid to win," while Kordestani in charge of business development and sales warned "You're betting the company if you do that." According to Auletta account in the book Page replied to Kordestani "we should be able to monetize the pages, if not we deserve to go out of business."

Whether or not those words are accurate that deal points out a critical aspect. At that point, Page and Brin were not only the engineers that had created PageRank but most of all shrewd entrepreneurs that understood the importance to close the right deals to kill competitors and dominate the market!

Overture sued for patent infringement then Yahoo settled the lawsuit with Google

Not long after the adoption of Google AdWord Overture sued it for patent infringement. The claim was the Google had copied the Overture model. However, after losing the AOL deal Overture stock plunged 36 percent, with its stock at $21.99. Although the company would keep making high profits margins, it would never recover from that. In fact, in 2003 Yahoo bought Overture for $1.63 billion, valuing it at $24.63, roughly a 15 percent premium compared to its closing at the time of the deal. 

Now part of Yahoo, in 2004, Google settled the Overture dispute. As reported on NY Times "Google agreed to give Yahoo 2.7 million shares, worth $291 million to $365 million if the shares sell within the range of $108 to $135 that Google has estimated for its initial offering price."

It was the end of Overture and the rise of the most influential tech giant, today worth more than eight hundred billion dollars.

A few deals can make a difference between a failed business and a multi-billion dollar company

The reason why I focused on this story is to emphasize the importance of distribution for any business. Even the most innovative technology without a proper distribution strategy is doomed. Thus, Google and its founders have been most of all shrewd businessmen before being engineers.

The Overture story and the AOL deal, show us just how at a certain point in time business looks way more like a warfare. Although we like to believe in stories of enlightened entrepreneurs that don't focus on competition but rather just on creating value for their customers. There is a particular moment in the life of any business where the difference between getting a deal or losing it means life or death. In those moments a businessperson will do what it takes to make his company survive.

The post The Deal That Made Google The Tech Giant We Know Today appeared first on FourWeekMBA.

Why Technology Is Not Neutral And Why You Should Care

 

I usually don't like to write opinion pieces as in most cases those are based on personal judgments, entirely subjective. However, as I deal more and more with technology, I get the same answer from most people when I show them my concerns about recent tech giants like Google and Facebook "those are just tools, they are neutral, they are not an end," Although those considerations might make sense at first they are wrong!

There is no such thing as neutral technology; there is no such thing as a tech tool that is just a tool. The applications we use on a daily basis aren't neutral at all. They have built-in biases, incentives that make us take certain actions. In this piece, I want to focus on two applications that each day are used by billions of people: Google and Facebook.

I'm selecting those two - this is not cherry picking - based on the applications those tech giants have been able to build or acquire throughout the years. Those applications are part of the daily habits (or vices) of billions of people. Apps like WhatsApp, Instagram, Facebook, Google, Google Docs, Google Maps and so on are so ingrained in our daily routine that we barely think they belong to the same companies that although offer us free tools they also have a clear commercial logic!

The curse of engineers turned advertisers

Matt is an engineer; he got just hired by Google. He wakes up one morning extremely excited to go to work until he sits at his desk and he's given his first tasks "figure out a way to make more money for our advertising network" they told him.

Although, there is no Mark (it is a fictional character) imagine the curse of an engineer graduated with top grades, just hired by Google, excited and ready to "make the world a better place" that ends up in having a bunch of tasks mostly related on how to make more money to Google's advertising networks!

This isn't just a thought that permeated my mind. But it seemed to be a legitimate worry that Google's founders had when back in the 90s they were trying to figure out how to make money with their search engine. At the time after looking for existing companies to acquire their technology and not able to find the right deal, Brin and Page went on to figure out how to make a profit with their tool.

In the article "The Future of Google: The Curse of Engineers Become Advertisers" I looked at a bit of history of the most prominent search engine on earth. And the most interesting part is that when Google started out, Brin and Page didn't want it to be associated with advertising. There was a specific reason for that as they specified too in a paper entitled "The Anatomy of a Large-Scale Hypertextual Web Search Engine" they specified "historical experience with other media, we expect that advertising funded search engines will be inherently biased towards the advertisers and away from the needs of the consumers."

Things swiftly changed when Google adopted the Google AdWords network which allowed businesses to bid on keywords. That's how it became a commercial search engine. Most people think of Google as the place where they can find the "best" information. But what does "best" mean?
The rise of deceptive AI tools

Recently Google published for the first time a manifesto that comprised the most important principles in developing AI tools. That manifesto consisted of seven principles:

1. Be socially beneficial 

2. Avoid creating or reinforcing unfair bias

3. Be built and tested for safety

4. Be accountable to people

5. Incorporate privacy design principles

6. Uphold high standards of scientific excellence

7. Be made available for uses that accord with these principles 

Although those principles make sense, ethics is not an easy matter, and of course, the role of the engineer is to find practical applications but weight them against ethical and social concerns. Just about a month before Google had launched a machine learning tool able to simulate a human conversation with incredible accuracy. If you look at the video you won't be able to notice any difference between Google Duplex and the human on the other side of the phone line:

As pointed out recently on Tech Crunch:

“Google’s experiments do appear to have been designed to deceive,” agreed Dr Thomas King, a researcher at the Oxford Internet Institute’s Digital Ethics Lab, discussing the Duplex demo. “Because their main hypothesis was ‘can you distinguish this from a real person?’. In this case it’s unclear why their hypothesis was about deception and not the user experience… You don’t necessarily need to deceive someone to give them a better user experience by sounding naturally. And if they had instead tested the hypothesis ‘is this technology better than preceding versions or just as good as a human caller’ they would not have had to deceive people in the experiment.

In short, although Google might be successful in tackling engineering issues, it might be less so in tackling ethical ones.

Data? Facebook takes it all

In 2014 Facebook bought WhatsApp, a messaging app used by millions of people for $19 billion. Since the start, WhatsApp has not been thought of as an application to be used for advertising purposes. WhatsApp founders who worked for a combined twenty years at Yahoo didn't want their app to have anything to do with advertising.

As pointed out in a 2012 blog post entitled "we don't sell ads," which is worth reading:

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Brian and I spent a combined 20 years at Yahoo!, working hard to keep the site working. And yes, working hard to sell ads, because that's what Yahoo! did. It gathered data and it served pages and it sold ads.

We watched Yahoo! get eclipsed in size and reach by Google... a more efficient and more profitable ad seller. They knew what you were searching for, so they could gather your data more efficiently and sell better ads.

These days companies know literally everything about you, your friends, your interests, and they use it all to sell ads.

When we sat down to start our own thing together three years ago we wanted to make something that wasn't just another ad clearinghouse. We wanted to spend our time building a service people wanted to use because it worked and saved them money and made their lives better in a small way. We knew that we could charge people directly if we could do all those things. We knew we could do what most people aim to do every day: avoid ads.

No one wakes up excited to see more advertising, no one goes to sleep thinking about the ads they'll see tomorrow. We know people go to sleep excited about who they chatted with that day (and disappointed about who they didn't). We want WhatsApp to be the product that keeps you awake... and that you reach for in the morning. No one jumps up from a nap and runs to see an advertisement.

Advertising isn't just the disruption of aesthetics, the insults to your intelligence and the interruption of your train of thought. At every company that sells ads, a significant portion of their engineering team spends their day tuning data mining, writing better code to collect all your personal data, upgrading the servers that hold all the data and making sure it's all being logged and collated and sliced and packaged and shipped out... And at the end of the day the result of it all is a slightly different advertising banner in your browser or on your mobile screen.

Remember, when advertising is involved you the user are the product.

At WhatsApp, our engineers spend all their time fixing bugs, adding new features and ironing out all the little intricacies in our task of bringing rich, affordable, reliable messaging to every phone in the world. That's our product and that's our passion. Your data isn't even in the picture. We are simply not interested in any of it.

When people ask us why we charge for WhatsApp, we say "Have you considered the alternative?"

In 2016, almost two years after the Facebook acquisition, WhatsApp terms of service were changed to include more "integrations" between WhatsApp and Facebook products. That put it shortly meant Facebook started to leverage on WhatsApp data to become more valuable to businesses, thus earn more money on their advertising platform.

"There is nothing new to the rise of those advertising giants," said average Joe

Another common phrase that you might hear around is the fact that advertising isn't new. And that just as mass media technologies like TV and Radio have taken over the world in the previous century, so search engines and social media are taking over our world now.

That isn't the case for several reasons; I'll focus on a couple of reasons here. First, TV and Radio were technologies and not necessarily tech giants. Today, we're assisting to the rise of tech giants, like Google and Facebook that alone can control the attention of billions of people on a global scale. Second, back in the days, advertisers had a colossal power thanks to mass media technologies. However, their message was highly undifferentiated. In short, they had to communicate the same message to millions of people. That made the message wide and spread, thus creating the so-called "pop cultures." Today instead social media like Facebook allow us to send very specific messages to a narrow audience by accessing personal data to segment them at the whole level. That instead of creating pop cultures, it generates "filter bubbles" that might reinforce our biases.

Beware of the commercial logic

One heuristic that I think each of us can use to be more aware and conscious of the logic behind those tech giants is to understand the way they make money. Just like in real life when dealing with someone that is trying to sell us something we become more aware of the fact that person might have hidden interests, I believe the best way to deal with those modern technology tools is similar to the way you'd deal with the salesman on the street. That's also why on this blog I often tackle business models. I believe those can give you a great insight into how those companies "think" and want you to behave to maximize their profits.

Shouldn't technology create more sustainable business models?

When by the end of the 1800s newspaper had become advertising outlets that sold for a meager fee while monetizing mostly on businesses ads. It was the beginning of industry - that of news - that carried intrinsic biases and distortions that persist nowadays. As technology advances, humanity has hope for it to build a better world. In part, this belief is based on the fact that people behind those technologies are engineers, thus not subject to common biases. In reality, an engineer might not be equipped to understand or even think ethical matters are important. But those might be the worse people to advance our society, for a simple reason. Often ethics is not a matter of optimization. Quite the opposite, when you introduce a utilitarian or optimization metric to an ethical dilemma, you might make it worse.

As Google and Facebook showed, those same engineers that invented super smart tools, also adopted old business models, mainly borrowed by the media industry that adopted them in modern times (by the mid-1800s). Thus, the question that keeps staring back at me is "shouldn't technology also innovate regarding monetization strategies to create more sustainable business models?"

Once again, probably myself, just like the rest of the world is putting too much hope into what technology can and should do. Therefore, the best way to go ahead is to be always a skeptic and ask any tech giant promising us the moon "how do you make money?"

The post Why Technology Is Not Neutral And Why You Should Care appeared first on FourWeekMBA.

How Does WhatsApp Make Money? WhatsApp Business Model Explained

 

Founded in 2009 by Brian Acton, Jan Koum WhatsApp got acquired by Facebook on February 2014 for $19B. In 2016 it was integrated more and more in Facebook products which allowed WhatsApp to focus more on interactions between its users and businesses. In 2018 WhatsApp rolled out customers' interactions services, and it started to make money on slow responses from companies. We don't know precisely how much revenues WhatsApp makes as it is not specified in Facebook Inc. financial statements.  

WhatsApp origin story

Koum and Brian Acton who had previously spent 20 years combined at Yahoo founded WhatsApp in 2009.

As reported on CNBC Jan Koum affirmed:

"It started with me buying an iPhone; I got annoyed that I was missing calls when I went to the gym." 

That's how they managed to build an app that made them show their status, and he added: "We didn't set out to build a company. We just wanted to build a product that people used."

In 2009 WhatsApp got its first seed round for $250k. In a few years, WhatsApp became a hit and in 2011 and 2013 WhatsApp got $60 million from Sequoia Capital with the first round of $8 million and the second round of $52 million.

The name WhatsApp is a pun on the phrase What's Up, and it started as an alternative to SMS. 

Advertising as a broken business model 

As reported on the WhatsApp blog by its founders Koum and Brian Acton:

When we sat down to start our own thing together three years ago we wanted to make something that wasn't just another ad clearinghouse. We wanted to spend our time building a service people wanted to use because it worked and saved them money and made their lives better in a small way. We knew that we could charge people directly if we could do all those things. We knew we could do what most people aim to do every day: avoid ads.

Advertising isn't just the disruption of aesthetics, the insults to your intelligence and the interruption of your train of thought. At every company that sells ads, a significant portion of their engineering team spends their day tuning data mining, writing better code to collect all your personal data, upgrading the servers that hold all the data and making sure it's all being logged and collated and sliced and packaged and shipped out... And at the end of the day the result of it all is a slightly different advertising banner in your browser or on your mobile screen.

Remember, when advertising is involved you the user are the product.

This showed how reluctant they were about advertising as a business model. The paradox though is that in a couple of years the company would be acquired by the largest digital advertising network, after Google.

The Facebook acquisition 

It was June 18, 2012, almost two years before WhatsApp got sold to the most profitable advertising network on earth, Facebook Inc.

In a previous post they said:

So first of all, let's set the record straight. We have not, we do not and we will not ever sell your personal information to anyone. Period. End of story. Hopefully this clears things up.

On February 19, 2014, when Facebook acquired WhatsApp. As reported on Facebook financial statements Facebook "paid approximately $4.6 billion in cash and issued 178 million shares of Class A common stock in connection with the acquisition of WhatsApp" this is how it was announced on WhatsApp blog:

Almost five years ago we started WhatsApp with a simple mission: building a cool product used globally by everybody. Nothing else mattered to us.

Today we are announcing a partnership with Facebook that will allow us to continue on that simple mission. Doing this will give WhatsApp the flexibility to grow and expand, while giving me, Brian, and the rest of our team more time to focus on building a communications service that’s as fast, affordable and personal as possible.

Here’s what will change for you, our users: nothing.

WhatsApp will remain autonomous and operate independently. You can continue to enjoy the service for a nominal fee. You can continue to use WhatsApp no matter where in the world you are, or what smartphone you’re using. And you can still count on absolutely no ads interrupting your communication. There would have been no partnership between our two companies if we had to compromise on the core principles that will always define our company, our vision and our product.

WhatsApp founders remarked once again that its business model would not change toward anything related to third-party ads. Things would start to change in a couple of years.

The freemium business model

Once WhatsApp had financial support to keep growing, it started to leverage the freemium business model to gain traction even more. As explained on their blog:

That's why we're happy to announce that WhatsApp will no longer charge subscription fees. For many years, we've asked some people to pay a fee for using WhatsApp after their first year. As we've grown, we've found that this approach hasn't worked well. Many WhatsApp users don't have a debit or credit card number and they worried they'd lose access to their friends and family after their first year. So over the next several weeks, we'll remove fees from the different versions of our app and WhatsApp will no longer charge you for our service.

Naturally, people might wonder how we plan to keep WhatsApp running without subscription fees and if today's announcement means we're introducing third-party ads. The answer is no. Starting this year, we will test tools that allow you to use WhatsApp to communicate with businesses and organizations that you wantto hear from. That could mean communicating with your bank about whether a recent transaction was fraudulent, or with an airline about a delayed flight. We all get these messages elsewhere today – through text messages and phone calls – so we want to test new tools to make this easier to do on WhatsApp, while still giving you an experience without third-party ads and spam.

WhatsApp started to focus more on communication between businesses and its users to create a line of products that could be monetized by selling services to companies using WhatsApp features.

Facebook takes over

The time came when Facebook finally started to take advantage of WhatsApp data to sell more of its ads. As reported on the WhatsApp blog:

The updated documents also reflect that we’ve joined Facebook and that we've recently rolled out many new features, like end-to-end encryption, WhatsApp Calling, and messaging tools like WhatsApp for web and desktop.

But as we announced earlier this year, we want to explore ways for you to communicate with businesses that matter to you too, while still giving you an experience without third-party banner ads and spam. Whether it's hearing from your bank about a potentially fraudulent transaction, or getting notified by an airline about a delayed flight, many of us get this information elsewhere, including in text messages and phone calls. We want to test these features in the next several months, but need to update our terms and privacy policy to do so.

That policy change created a set of backlashes that remain as concerns. As pointed out on Facebook financials for 2017:

The Irish Data Protection Commissioner has challenged the legal grounds for transfers of user data to Facebook, Inc., and the Irish High Court has agreed to refer this challenge to the Court of Justice of the European Union for decision. We also face multiple inquiries, investigations, and lawsuits in Europe, India, and other jurisdictions regarding the August 2016 update to WhatsApp’s terms of service and privacy policy and its sharing of certain data with other Facebook products and services, including a lawsuit currently pending before the Supreme Court of India. If one or more of the legal bases for transferring data from Europe to the United States is invalidated, if we are unable to transfer data between and among countries and regions in which we operate, or if we are prohibited from sharing data among our products and services, it could affect the manner in which we provide our services or adversely affect our financial results

It is important to remark that the terms of service changes applied to things like:

Enable you to communicate with businesses on WhatsApp. For example, if you visit a business's Facebook page, you might see a button that lets you easily open a WhatsApp chat with them.

However, it is undeniable that in 2016 it finally started a process of monetization that revolved around data sharing between WhatsApp and Facebook products.

In 2017 the WhatsApp founders left Facebook and $1.3B in stock options, presumably because desperate to leave the company. As reported by bizjournals, "Jan Koum and Brian Acton have more recently clashed with Facebook CEO Mark Zuckerberg and COO Sheryl Sandberg, and quit the company, leaving hundreds of millions of dollars worth of unvested stock options on the table. Acton, who quit in November 2017, walked away from $900 million in unvested shares, while Koum, who will exit Facebook in August, will leave $400 million in unvested shares, the Wall Street Journal reports."

Following Cambridge Analytica scandal, in March 2018, Brian Acton also launched a hashtag campaign - #deletefacebook - which in a way backfired on him:

It is time. #deletefacebook

— Brian Acton (@brianacton) March 20, 2018

Do we know how much money WhatsApp makes?

As part of Facebook Inc., we don't know exactly how much money WhatsApp generates. That's also because Facebook is not obliged to report the breakdown of its revenues. However, it is undeniable that WhatsApp is a valuable asset in Facebook. As reported by Investopedia "according to the 2014 Facebook Form 10-Q, in the nine months preceding September 30, 2014, WhatsApp generated revenue of $1,289,000."

WhatsApp becomes a solution provider: A quick glance at customers' interactions management   

In August 2018 on its blog, WhatsApp reported the creation of new tools to allow businesses to connect to users which included three kinds of interactions:

Request helpful information
Start a conversation
Get support

In this way, businesses will start paying for certain interactions with users to manage their customers' interactions.  

As reported on the WhatsApp website:

From time to time, a business may use a solution provider to help provide the tools it needs to send and receive messages from you. Businesses rely on these solution providers to store, read and respond to your messages.

The business you're communicating with has a responsibility to ensure that it handles your messages in accordance with applicable law and its privacy policy. For more information on the provider's privacy policy, please contact that business directly.

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While the app is free of charges, some services will be paid. For instance, if a business that uses WhatsApp will reply to a customer later than 24 hours, it will pay a fixed charge based on the country.

Summary and conclusions

WhatsApp started as an alternative app that could be used to give statuses updates and message. It gained traction until it was acquired for $19B by Facebook.

Starting in 2016 WhatsApp changes its terms of service to integrate its services with Facebook business products.

This created some concerns about the data shared between WhatsApp and Facebook. In 2018 both WhatsApp founder presumably left Facebook due to conflicts with Mark Zuckerberg.

Still, in 2018, WhatsApp launched a new service that allowed businesses to reply to customer support request for free for the first 24 hours. After that, the company would be charged.

It is clear to me that Facebook, although it tried, to get as much data from WhatsApp in order to sell more advertising, it had also lawsuits due to that process.

Thus, that makes it harder and harder to integrate WhatsApp into the Facebook advertising network. Therefore, the future seems more focused on building specific messaging services for businesses. Will this turn out to be a profitable industry for Facebook?

The post How Does WhatsApp Make Money? WhatsApp Business Model Explained appeared first on FourWeekMBA.

What Is Weighted Average Cost of Capital? WACC in a Nutshell

 

The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

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Why would you be interested in knowing the cost of debt, equity and eventually the cost of capital? 

Money has a time value, and if we want to know if it is convenient for us to undertake an investment, we must discount the invested capital for the proper discount rate. 

For instance, imagine for a second you want to invest in a new venture, but you also want to make 25% annually on that venture. Thus you invest $100K, and you want to make $25K by the end of the year. 

The 25% is your hurdle rate. Consequently, if your expected return on this investment isn’t at least 25%, you won’t go for it. To compute the expected return on an equity investment, we will have to determine the cost of equity. 

Imagine that you assessed the cost of equity on the new venture and it turns out to be 15%. This return is not satisfactory enough for you to invest. Therefore you will not commit your money.

On the other hand, if you want to know the proper discount rate for the overall asset of the organization we will have to resort to the WACC formula:

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In short, to compute the cost of capital, we will have to adjust the cost of equity and the cost of debt according to the weight of each component of the capital structure of the firm. 

For instance, the same company will have a lower or higher cost of capital according to the financing mix it chose to finance its operations.

What is the cost of debt?

The cost of debt can be defined as the amount of interest a firm has to pay over the borrowed capital. In other words, each time a firm borrows a sum of money, within some days, months or years the firm will have to pay back what is called the principal plus interests. 

For instance, I borrow $1,000 at 10% simple annual interest due in one year; after one year I will have to pay back the $1,000 (principal) plus $100 (interests).

Now you may wonder what determines the interest payment? Solvency. How to measure solvency? Of course, you can logically understand that a company that is more reliable will also be perceived as safer. 

Thus it will able to borrow money at a lower cost, therefore pay lower interests. Yet this can be an explanation sufficient for the laymen, not the financial manager. Let’s take a look at how debt affects both balance sheet and income statement:

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From the picture above you can see that under the liability section of the balance sheet we have two forms of debt: short and long-term debt and they both produce interests. 

These interests will be paid with the portion of income that is left after paying the operating expenses, which in finance lingo is called EBIT (earnings before interests and taxes). 

When the EBIT is a few times greater than the interest expenses, this is a good sign. For instance, a firm that has a monthly EBIT of $1,000 and has to pay $100 in monthly interest expenses, it means that the EBIT is 10x the interest payments (1,000/100), making such firm very reliable. 

In financial jargon, this is called the Interest Coverage Ratio (EBIT/Interest Expense), and this measure helps us in the assessment of the credit condition of the company. 

Therefore, the higher the interest coverage ratio, the better the credit conditions of the firm, the lower the interests the firm will pay on its debt. I would call this the “debt positive spiral:”

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A higher interest coverage ratio determines a lower cost of financing. This, in turn, brings a higher EBIT in comparison to interest expenses, therefore an interest coverage ratio improvement and so on, up to the point in which the interest rates the company pays on its debt get very close to the risk-free rate. 

This positive spiral happens when a company is using an optimal capital structure, but when the debt gets out of hand, we have the opposite scenario, the “debt negative spiral:”

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In this scenario a lower interest coverage ratio determines higher interest rates on debt financing, which in turn will increase the interest expenses, thus making them grow faster than the EBIT, therefore determining a lower interest coverage ratio and so on, up to the point in which the firm goes bankrupt.

Hot to Measure the Interest on Debt or the Cost of Debt

The interest that a firm pays on the borrowed capital can be defined as its cost of debt. In part this interest is determined by how reliable a company is. 

On the other hand, there is a part of this interest that cannot be determined by the organization’s balance sheet, but from other factors. Let’s see below what the interest on the debt is comprised of:

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As you can see from the image above the primary building blocks of the interest on the debt are the risk-free rate and the spread. 

The risk-free rate is the rate returned by an asset that carries no risk at all, such as the U.S. Treasury bill. 

On the other hand, the spread has two primary layers: the country and the company spread. In this specific case, I am referring to corporate debt. 

Furthermore, if we want to know the cost of debt for a company that operates in Italy, we must start from the risk-free rate, and eventually add up the country spread and the company spread, this is how we get the cost of debt financing for that firm. 

Let’s say that we want to compute the cost of debt for Fiat Chrysler Automotive Group, what do we need to know? We can do that in three steps:

Find out the risk-free rate. Keep in mind that FIAT is an Italian company, thus instead of using the U.S. Treasury Bill as the risk-free rate, we will have to find the European equivalent of it.
Find out the Italian country spread, or the difference between the risk-free rate asset and the long-term Italian bond.
Find out FIAT’s credit rating, which will allow us to determine the company spread.

See the three steps below:

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As you can see from the image above, in the first step we determined the risk-free rate. Since Fiat Chrysler Group is headquartered and principal operations in Italy we cannot we had to find the European equivalent of the U.S.  Treasury Bond. In fact, I took the 10-year rate for the German Bond (called Bund), which rate is 0.29%.

Furthermore, in the second step, I took the 10-year spread between the German bund and the Italian BTP (BTP is the equivalent of the American bond), which is  1.26%.

In the third step, I looked up at the rating for FIAT Group, and according to that, I looked at the table to determine the company’s spread based on its credit rating, which turned out to be 3.61%. 

Eventually, I determined a cost of debt for FCA Group of 5.16%. This means that FCA Group has to pay at least 5.16% to its creditors to issue a 10-year corporate bond.

Cost of Equity and CAPM

When the investor or equity holder places his money in a venture, he will expect a certain return that we computed through the CAPM, and that is how we determined the cost of equity.

The same principle applies to the financing decision; we will use theCAPM as the primary framework to assess that cost of equity.

What to read next?

What is the capital asset pricing model?
What is a financial option? 
What is risk in finance?
What is a financial ratio? 
13 financial ratios formulas 

The post What Is Weighted Average Cost of Capital? WACC in a Nutshell appeared first on FourWeekMBA.

What Is the Capital Asset Pricing Model? CAPM Framework Explained

 

In finance, the capital asset pricing model (or CAPM) is a model or framework that helps theoretically assess the rate of return required for an asset to build a diversified portfolio able to give satisfactory returns. 

CAPM assumptions

The CAPM or Capital Asset Pricing Model, although unrealistic, it is still the most used in financial analysis. The reason I say unrealistic is that the CAPM even assumes that financial markets are perfect and investors rational. 

Besides the debate about CAPM’s ability to predict reality, I am going to show you in detail how it works. In this section, I will use a sort of reverse engineering approach. 

Almost like a Quentin Tarantino’s movie that starts from the end and slowly unravels until the beginning of the story, I will start from the CAPM formula and reverse engineer it backward:

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Don’t worry if it all looks nonsense right now. Just keep in mind that since returns are situated in the future, the purpose of this model is to compute the expected return of a security. Also, to do so, we will have to assess several factors. See below the meaning if the formula:

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Now we can break down the formula. The expected return of an asset is given by the risk-free rate the Beta of the asset in which we invested multiplied by what is called the market risk premium (provided by the expected return of the market portfolio minus the risk-free rate). 

Fine, what now? To compute the expected return of an asset we have to assess three variables:

Risk-free rate
Beta
The expected return of the market

Let me explain these variables further.

What is the risk-free rate?

In finance lingo, the risk-free rate is the % amount you will receive to invest in an asset that carries no risk. This means that you expected returns would be the same as your actual returns.

Unless you are in Wonderland, there is no such thing as an asset that carries no risk at all. In fact, after the financial crisis of 2008, we understood how interconnected is the whole world economy and how a butterfly flap in Mexico can cause a tornado in China.

This effect called butterfly effect, and it is used in chaos theory to explain how a tiny change in the initial state of a system can then have unpredictable consequences to its “final state.” 

This happens, due to the complexity of the system. On the other hand, the risk-free rate will help us in determining the additional return we have to expect to decide whether that investment is worth undertaking.

In fact, assuming investors are rational, they will ask for an additional return for each level of additional risk. In other words, the risk-free rate works like a baseline or starting point from which we build our model. Practically speaking what a risk-free rate is?

For instance, the most known risk-free asset is the U.S. Treasury. In short, you buy a piece of the U.S. debt, and in exchange, they give you interests, plus the capital invested.

What is the time value of money?

What is the difference between a dollar today and a dollar tomorrow? You may argue that a dollar is a dollar and either you have it today or tomorrow is not going to make any difference. 

Instead, the first principle that we learn in finance is that “A dollar today tomorrow” and this has nothing to do with inflation. In fact, assuming no inflation at all this principle still applies. Why?

Just because when you have the money available, it can be invested or it can earn interests. In finance, this concept is called the time value of money. 

In fact, until you are not receiving the money, you are not earning interests, and in turn, you are losing many opportunities. You may wonder how do you determine whether an amount of money today is better than in the future. 

To solve the mystery, we will have to explore two new concepts: present and future value. 

What is the present value?

The present value tells you how much is worth today a sum of money that you will receive in the future. To compute the present value, we will have to take the amount of money we will receive in the future and divide it by (1 r)^t.

We will call r the discount rate and t the number of years corresponding to when the money will be received.

For instance, let’ assume that you want to save money for your kids. In short, you want to create a fund so that you will be able to pay for their education. 

Your target is to save $100k in 10 years. Assuming that the fund offers a 5% simple annual interest, how much do you have to invest today to have $100k in the future? Easy:

PV = Money in the future / (1 discount rate)^Number of years in the future= 100,000 / (1 5%)^10 = $61,391

This means that if we want to receive $100k in ten years, we will have to invest $61,391 today!

What is the future value?

Imagine now the opposite scenario. You have $100k today, how much will it be worth in the future? To compute the present value we took the future amount and divided it by (1 r)^t. 

To compute the future value, we will have to take the present amount and multiply it by (1 r)^t. Thus, assuming you want to know how much will $100k worth in 10 years, how do you do that? Assuming a risk-free rate of 5% simple annual interest:

FV = Money you have today * (1 discount rate)^ number of years in the future =

100,000 * (1 5%)^10 = 162,889

For the principle that a dollar today is worth more than a dollar tomorrow, in ten years, at 5% simple annual interest, your $100K will be worth $162,889!

Now we covered the time value of money and thus how present and future value work, we can move forward and find out what Beta is.

What is the Beta in CAPM?

Regression analysis determines how an independent variable influences a dependent variable. Statistically speaking this means that we will collect a bunch of data to see the existing relationship between our stock and the market portfolio. 

In fact, the objective here is to determine to what extent the stock we are analyzing is more or less risky compared to the market portfolio. 

Thus, once collected the data they will appear on a graph that has two axes (x, y) and in that set of data, we will fit a line. 

The Beta gives the slope of that line. In short, the higher the Beta, the higher will be the slope of the line and vice versa. In statistics, this kind of regression is also called linear regression.

Beta (CAPM) formula

The formula to compute our Beta is given by:

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The covariance is a statistical measure that allows us to understand if two variables are positively or negatively correlated. For instance, a positive covariance means that two variables move in the same direction, and vice versa. 

The variance instead is a statistical measure that shows how values move away from the mean. Thus, it shows how values are spread around the mean. In fact, when there are larger moves around the mean, this also makes the stock riskier.

*Together with the variance another significant measure of risk is the standard deviation (σ), which is the square root of the variance. When for instance, you see two stocks, A and B, where A has a σ of 20%, while B has a σ of 5%, A will be riskier than B. Furthermore, if you expect the same return between A and B, let’s say 10%, you will be better off to pick B. Why so? For the same level of return, you have a lower level of risk.

Going back to the Beta. Once we divide the covariance of the two variables (stock and market portfolio) and the variance of the market portfolio we will determine for each movement up or down of the market portfolio, what is the movement of the security we are analyzing.

That’s it!

What to read next?

What is a financial option? 
What is risk in finance?
What is a financial ratio? 
13 financial ratios formulas 

The post What Is the Capital Asset Pricing Model? CAPM Framework Explained appeared first on FourWeekMBA.

What Is Financial Risk? Financial Risk Explained

 

The Oxford Dictionary defines risk as:

“A situation involving exposure to danger” and it goes on “The possibility that something unpleasant or unwelcome will happen.”

Thus we want to define what is dangerous and what is this unpleasant thing we want to avoid. 

A first obstacle stands in the way of determining risk. In fact, each of us seems to have a different perception of what danger is. 

For instance, you may be a firefighter that is so brave to jump into homes on fire and save people and still be very fearful when it comes to investing.

How do we take investing decisions?

Investing in corporate finance lingo means: 

“Buying assets that earn a return greater than the minimum acceptable hurdle rate” (A. Damodaran).

Also, A. Damodaran used an interesting definition. He starts from the Chinese characters that express the word “crisis” and goes on to derive the two main aspects to consider when undertaking an investment decision:

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As you can see the word “crisis” is comprised of two characters and each one has its meaning. In fact, the first means danger and the second opportunity. Thus, let’s start with this definition.

Each time an investment decision has to be taken, the investor faces the danger (which in finance lingo is called risk) to lose the capital invested (or not generating enough returns), while he also put himself in the condition to be highly rewarded (in finance this reward is called return) for the undertaken risk.

To simplify we have to find the % return that would convince the investor to risk his own money. To find this % return we have to study and understand what is risk and how to assess it.

What Is a financial risk?

The Oxford Dictionary defines risk as:

“A situation involving exposure to danger” and it goes on “The possibility that something unpleasant or unwelcome will happen.”

Thus we want to define what is dangerous and what is this unpleasant thing we want to avoid. 

A first obstacle stands in the way of defining risk. In fact, each of us seems to have a different perception of what danger is. 

For instance, you may be a firefighter that is so brave to jump into homes on fire and save people and still be very fearful when it comes to investing!

Also, in the investing world, there is a term used by behavioral economists, which is “loss aversion.” In short, it seems that we perceive losses way more than we perceive gains. 

This bias was first elaborated and verified by Amos Tversky and Daniel Kahneman. In other words, a 10$ gain is perceived more than twice less satisfactory of a loss of the same amount. 

This seems to be a built-in bias. Thus, we can do our best to define risk, although our definition may not be perfect.

Since risk is different according to the perspective of the investor, A. Damodaran proposes a useful approach, which is that of the “marginal investor.” 

In short, to define risk, you have to identify the marginal investor first. But who is this marginal investor?

Who is the marginal investor?

The marginal investor is the person or institution that at any time may hold the stocks of a company and therefore also influences its prices. 

The next step is to identify the marginal investor. How? Well, we have to look at the ownership structure of our target company. For instance, let’s look at who the marginal investors are for Apple:

As you can see from the image provided by Morningstar.com Apple’s principal shareholders are Institutions and Mutual Funds. 

In fact, insiders hold just a tiny part of Apple’s issued shares. Thus, we can easily assume that Apple’s marginal investors are well diversified. 

That means that they will have a lower risk compared to a non-diversified investor. Why?

Let’s assume that you have all your capital invested in one company. What happens if that company goes bankrupt? You will lose all your wealth, wouldn’t you? 

Conversely, if you have your eggs in different baskets if one basket falls you will still have the other eggs; If you are an individual, you can diversify your financial risk by investing in various stocks or for instance in a stock index. 

What about businesses? How can a business diversify (thus reduce) its risk exposition? Let’s see the different components of risk.

Financial risk components 

There are five components of risk:

Project specific
Competitive
Industry
International
Market

If you are familiar with businesses, you may already know that they face several risks. For instance, although opening a restaurant always seems a good business idea, think for a second how many risks it faces.

First, if you want to run a successful restaurant you have to experiment new dishes continually. Now some dishes will work out some will not. 

Those that won’t work will also have a cost for you. We will call the risk of these dishes not working out project-specific risk. Second, you have to be better than the other dozens of restaurants in the neighborhood. 

To do so, you will cut prices, or improve the quality of the product and so on. You won’t know if this will work out for sure. Thus, we will call this danger competitive risk. 

Third, you have to be able to manage your budget, since the price of the ingredients for your recipes steadily increases. Also, you have to make sure the restaurant is always clean and that it is compliant with legal standards. 

Thus, you have to follow periodically any regulation changes that may be in the industry. And also, update your system to make sure the restaurant is run efficiently. 

All those things cost you money and can also endanger your business. Thus, we will call them industry risks. 

Fourth, if you opened a restaurant in another state, you want also to understand the regulations in that state. Assuming that the country also has a different currency, this will can affect your revenues either positively but also negatively. 

We will call this sort of danger international risk. And fifth, if an economic crisis strikes the restaurant will resent it. In fact, when economic conditions worsen people have less money to spend on their leisure activities. 

Thus, the revenues will considerably slow down. We are going to call this danger market risk. In conclusion, so far we identified five components of risk:

Project specific
Competitive
Industry
International
Market

The next question is “Until which extent can we get rid of risk?”

What financial risks can be managed? 

The primary objective of diversification is to reduce and manage risk. But the problem is that while some risk may be easily mitigated, others are not.

Perhaps, going back to the restaurant business, you may be able to diversify the project specific risk by trying out different dishes. For instance, you can play on the large numbers. 

If you try out ten new dishes, the chances are that nine out of ten will not work out. But the successful plate will generate more than enough revenues to cover the expenses incurred in trying out the other dishes plus an additional reward for the undertaken risk.

Also, if a successful restaurant just opened in your neighborhood, you could either compete with it or become an ally. How? Well, you may buy part of the ownership. 

This, in turn, will reduce the competitive risk. Huge corporations like Amazon, which bought Zappos, Facebook, which bought Instagram or Whatsapp and so on, use this same strategy. 

Now there is also the strategic reason for doing so. Perhaps, Zappos can make Amazon more valuable, but these deals are also driven by the necessity for these businesses to reduce the competitive risk.

Further, once the money from the restaurant business flows in you may want to consider investing it in other ventures as well. I did not say restaurants on purpose. 

In fact, if you keep investing in other restaurants, you may reduce your competitive risks, but this will not mitigate the industry risk. To diversify away this risk, you will invest in other industries. 

For instance, with the cash flow from the restaurant, you can buy a piece of real estate and rent it out.

Since you opened your restaurant in another state with a different currency and interest rates; Assume that you have a restaurant in San Diego, CA and you just opened another in Rosarito, Mexico. 

Although those restaurants are 50 minutes apart they are in different countries. In fact, in San Diego, you pay in dollars and Rosarito in pesos. 

A dollar is worth several pesos. Also, according to the World Bank Landing Rates U.S. has a 3.3% lending rate, while Mexico shows a 4.9%. 

Thus, you may want to borrow in U.S. dollars and finance the Mexico operations with that money, assuming they will accept dollars rather than pesos. In this way, you will diversify away part of your international risk!

A lot of hard work so far to take away some of the risk involved for being in business. Although you successfully managed to come so far, there is a form of risk that cannot be diversified. 

This is the market risk. In short, if the whole world economy will suffer (think of the 2008 global crisis), there is nothing you can do about it. As they say “A trouble shared is a trouble halved.” Hopefully, you saved enough money for the rainy days and will survive.

In conclusion, we analyzed the five components of risk and saw how they could be diversified away. Though, there is a component (market risk) that is not diversifiable. Let me summarize what we saw in this table below:

How do you Measure financial Risk?

So far we got two central concepts down, about risk. First, a risk is not an absolute concept but it somewhat depends on how well diversified is the marginal investor.

Also, we may argue that with new developments in behavioral economics we now know that there are also certain aspects related to risk (such as loss aversion and other built-in biases) that make risk an even more complicated topic. 

On the other hand, we are dealing with corporate finance; a world was shrewd financial managers assume that the marginal investors are rational. Thus, our second point is that marginal investors will tend to diversify their portfolios. Why?

Let me use an analogy here. I apologize in advance for using the Darwinian concept of evolution, but I believe it makes my point. In fact, natural selection works somewhere around these lines: nature has scarce resources (in most of the cases). 

Thus the individuals living in the same environment will tend to compete against each other for survival and reproduction. This will bring to the creation of strategies by each competing in the same situation. 

Eventually, nature will select the winning strategy and avoid the rest. In conclusion, these strategies will be passed on to progenies.

For instance, trees compete with each other for the sunlight. What is the best way to absorb sunlight? By being closer to the sun, thus by growing taller. 

For such reason, they tend to grow taller and taller until a forest will be created. While at the beginning of the process, you could see short trees, now they were utterly swept out. 

Thus, all the trees in the forest are tall, and they keep growing until they reach a limit to avoid losing their functionality (this is speculation). Eventually, all the trees in the forest will more or less have the same height. In short, there is a certain consistency.

If we go back to the financial world, we can use the same example. When all the marginal investors understand that the strategy to manage the risk is to diversify the portfolio, they all start to use diversification. 

On the other hand, there is a point in which the marginal benefit of diversifying will be null. In fact, as we saw there is a component of risk (market risk or systematic risk) that cannot be diversified. 

Consequently, if you hold ten stocks or one hundred, it does not make any difference. Instead, it just increases the cost associated with managing such a portfolio. 

In conclusion, all the marginal investors will hold diversified portfolios, which will carry only systematic risk. Thus, this means that wherever we look in the markets, we will find diversified investors. 

Conclusively, the simplest way to compute the risk of a security is to assess the systematic risk or that part of the risk that cannot be diversified away.

Disclaimer: this is not a financial counsel, neither a suggestion on how you should manage risk. Also, this isn’t necessarily the view of the author. But just an educational material intended to describe the definition of financial risks according to traditional corporate finance books. For financial advice consult a professional. 

What to read next? 

What is a financial option?
What is a financial ratio? 
13 Financial ratio formulas to analyze any business

The post What Is Financial Risk? Financial Risk Explained appeared first on FourWeekMBA.