- Company analysis and industry analysis are closely interrelated. Company and industry analysis together can provide insight into sources of industry revenue growth and competitors’ market shares and thus the future of an individual company’s top-line growth and bottom-line profitability.
- Industry analysis is useful for:
- Understanding a company’s business and business environment;
- Identifying active equity investment opportunities;
- Formulating an industry or sector rotation strategy; and
- Portfolio performance attribution.
- The three main approaches to classifying companies are:
- Products and/or services supplied;
- Business-cycle sensitivities; and
- Statistical similarities.
- Commercial industry classification systems include:
- Global Industry Classification Standard;
- Russell Global Sectors; and
- Industry Classification Benchmark.
- Governmental industry classification systems include:
- International Standard Industrial Classification of All Economic Activities;
- Statistical Classification of Economic Activities in the European Community;
- Australian and New Zealand Standard Industrial Classification; and
- North American Industry Classification System.
- A limitation of current classification systems is that the narrowest classification unit assigned to a company generally cannot be assumed to constitute its peer group for the purposes of detailed fundamental comparisons or valuation.
- A peer group is a group of companies engaged in similar business activities whose economics and valuation are influenced by closely related factors.
- Steps in constructing a preliminary list of peer companies:
- Examine commercial classification systems if available. These systems often provide a useful starting point for identifying companies operating in the same industry.
- Review the subject company’s annual report for a discussion of the competitive environment. Companies frequently cite specific competitors.
- Review competitors’ annual reports to identify other potential comparables.
- Review industry trade publications to identify additional peer companies.
- Confirm that each comparable or peer company derives a significant portion of its revenue and operating profit from a similar business activity as the subject company.
- Not all industries are created equal. Some are highly competitive, with many companies struggling to earn returns in excess of their cost of capital, and other industries have attractive characteristics that enable a majority of industry participants to generate healthy profits.
- Differing competitive environments are determined by the structural attributes of the industry. For this important reason, industry analysis is a vital complement to company analysis. The analyst needs to understand the context in which a company operates to fully understand the opportunities and threats that a company faces.
- The framework for strategic analysis known as “Porter’s five forces” can provide a useful starting point. Porter maintains that the profitability of companies in an industry is determined by five forces: 1) The threat of new entrants, which in turn is determined by economies of scale, brand loyalty, absolute cost advantages, customer switching costs, and government regulation; 2) the bargaining power of suppliers, which is a function of the feasibility of product substitution, the concentration of the buyer and supplier groups, and switching costs and entry costs in each case; 3) the bargaining power of buyers, which is a function of switching costs among customers and the ability of customers to produce their own product; 4) the threat of substitutes; and 5) the intensity of rivalry among existing competitors, which in turn is a function of industry competitive structure, demand conditions, cost conditions, and the height of exit barriers.
- The concept of barriers to entry refers to the ease with which new competitors can challenge incumbents and can be an important factor in determining the competitive environment of an industry. If new competitors can easily enter the industry, the industry is likely to be highly competitive because incumbents that attempt to raise prices will be undercut by newcomers. As a result, industries with low barriers to entry tend to have low pricing power. Conversely, if incumbents are protected by barriers to entry, they may enjoy a more benign competitive environment that gives them greater pricing power over their customers because they do not have to worry about being undercut by upstarts.
- Industry concentration is often, although not always, a sign that an industry may have pricing power and rational competition. Industry fragmentation is a much stronger signal, however, that the industry is competitive and pricing power is limited.
- The effect of industry capacity on pricing is clear: Tight capacity gives participants more pricing power because demand for products or services exceeds supply; overcapacity leads to price cutting and a highly competitive environment as excess supply chases demand. The analyst should think about not only current capacity conditions but also future changes in capacity levels how long it takes for supply and demand to come into balance and what effect that process has on industry pricing power and returns.
Need of Industry Analysis
Industry analysis, as a form of market assessment, is crucial because it helps a business understand market conditions. It helps them forecast demand and supply and, consequently, financial returns from the business. It indicates the competitiveness of the industry and costs associated with entering and exiting the industry. It is very important when planning a small business. Analysis helps to identify which stage an industry is currently in; whether it is still growing and there is scope to reap benefits or has reached its saturation point.
With a very detailed study of the industry, entrepreneurs can get a stronghold on the operations of the industry and may discover untapped opportunities. It is also important to understand that industry analysis is somewhat subjective and does not always guarantee success. It may happen that incorrect interpretation of data leads entrepreneurs to a wrong path or into making wrong decisions. Hence, it becomes important to collect data carefully.