By comprehending the operations of industries and companies and examining financial statements, analysts are able to forecast company performance and assess the worth of investing in a company or its securities. Industry analysis involves studying a particular sector of manufacturing, service, or trade. This knowledge of the industry in which a company operates is crucial for conducting an analysis of the company itself, known as company analysis. Analysts who specialize in equity or credit analysis often focus on one or multiple industries, leading to improved efficiency and collaboration in gathering and interpreting information.
This reading will cover the following inquiries:
- What are the commonalities and distinctions between various industry categorization systems?
- What is the process for an analyst to select a group of companies to compare?
- What are the critical elements to take into account when evaluating an industry?
- What benefits do companies in strategically advantageous industries have?
- How should an analyst approach studying and analyzing unfamiliar industries?
- What are the factors that impact individual companies?
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Outcomes of Learning
The individual must have the capability to:
- Outline the uses of conducting industry analysis and its connection to company analysis.
- Contrast the different methods used for classifying companies.
- Discuss the factors that impact a company’s vulnerability to changes in the business cycle, as well as the advantages and limitations of using industry and company descriptors such as “growth,” “defensive,” and “cyclical.”
- Describe existing industry classification systems and determine the appropriate classification for a company based on its activities and the given system.
- Explain how a company’s industry classification can be utilized to identify potential peer companies for equity valuation.
- Identify the essential components of a comprehensive industry analysis.
- Elaborate on the principles of strategic analysis for an industry.
- Discuss the impact of entry barriers, industry concentration, capacity, and market share stability on pricing power and competition.
- Describe different industry life-cycle models, classify an industry based on its life-cycle stage, and acknowledge the limitations of using this concept to forecast industry performance.
- Analyze the macroeconomic, technological, demographic, governmental, social, and environmental factors that influence industry growth, profitability, and risk.
- Compare the characteristics of representative industries from different economic sectors.
- Outline the necessary components of a thorough company analysis.
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In this passage, we have given a general outline of industry analysis and demonstrated common methods used by analysts to evaluate an industry.
The analysis of a company and its respective industry are closely connected. By analyzing both the company and industry, one can gain a better understanding of the factors contributing to industry revenue growth and the market shares of competitors. This allows for a prediction of a company’s future top-line growth and bottom-line profitability.
Conducting an analysis of the industry is beneficial for:
Gaining knowledge about the operations and surroundings of a company;
Discovering potential investments in the stock market;
Devising a plan for rotating between industries or sectors.
Attribution of portfolio performance.
There are three main methods for categorizing companies:
goods and/or offerings provided;
sensitivities to business cycles; and
similarities observed through statistical analysis.
Classification systems used in the commercial industry include:
The Global Industry Classification Standard is a widely used classification system in the industry.
- Sectors around the world according to Russell; and
The categorization system for industries, known as the Industry Classification Benchmark.
- Industry classification systems established by the government include:
The International Standard Industrial Classification of All Economic Activities is a classification system that categorizes all types of economic activities.
- Categorization of Economic Activities in the European Community based on Statistics;
The classification known as the Australian and New Zealand Standard Industrial Classification; and
- The classification system for industries in North America.
One shortcoming of existing classification systems is that the smallest unit of classification given to a company cannot always be considered as its peer group when conducting thorough fundamental analysis or valuation.
A peer group refers to a collection of businesses that participate in similar business operations, where their financial and worth are affected by closely interconnected elements.
The process of creating an initial roster of comparable companies:
If possible, review commercial classification systems. These systems can serve as a valuable starting point for identifying businesses within the same industry.
Examine the annual report of the company in question to analyze the competitive landscape. It is common for companies to mention their direct rivals.
Examine the annual reports of competitors in order to find additional potential companies for comparison.
Analyze trade publications within the industry to discover other companies with similar characteristics.
It is important to verify that each comparable or peer company generates a considerable amount of their revenue and operating profit from a comparable business activity as the subject company.
The level of competition and profitability among industries vary greatly. While some industries face challenges in achieving returns that exceed their capital costs, others possess advantageous qualities that allow most participants to attain strong profits.
The structural characteristics of an industry play a crucial role in determining the competitive landscape. Therefore, conducting an industry analysis is essential in addition to examining a company. To comprehensively comprehend the potential opportunities and threats a company faces, the analyst must have a grasp of the environment in which the company operates.
The strategic analysis framework known as “Porter’s five forces” is a helpful starting point. According to Porter, the profitability of companies in an industry is influenced by five forces: 1) The potential for new competitors to enter the market, which is affected by economies of scale, brand loyalty, cost advantages, customer switching costs, and government regulations; 2) the bargaining power of suppliers, which is determined by the possibility of finding alternative products, the concentration of buyers and suppliers, and the costs associated with switching or entering the market; 3) the bargaining power of buyers, which depends on customer switching costs and their capability to produce their own product; 4) the possibility of substitutes; and 5) the level of competition among existing competitors, which is influenced by the structure of the industry, demand and cost conditions, and the difficulty of exiting the industry.
The idea of obstacles to market entry deals with the level of difficulty for new competitors to enter and challenge established players, which can significantly impact the competitive landscape of an industry. When new competitors can easily enter the market, it is more likely to be a highly competitive environment, as established players will face competition from newcomers if they attempt to raise prices. This results in industries with low barriers to entry having less control over pricing. On the other hand, if established players are shielded by barriers to entry, they may have a more favorable competitive environment, allowing them to have greater control over pricing as they do not have to worry about being undercut by new entrants.
- The concentration of an industry can indicate the potential for pricing power and rational competition, but this is not always the case. On the other hand, industry fragmentation is a stronger indication of a competitive market and limited pricing power.
The impact of industry capacity on pricing is evident. When capacity is limited, participants have more control over pricing as the demand for goods or services surpasses the supply. On the other hand, when there is excess capacity, prices tend to decrease as there is intense competition to meet demand. In evaluating pricing power and returns, the analyst should consider both current and future capacity conditions. It is important to consider the time it takes for supply and demand to reach equilibrium and the influence this has on industry pricing power and profitability.
When studying the consistency of market share in an industry, it is akin to considering the obstacles for new entrants and the frequency at which they join the industry. A steady market share usually suggests a less competitive market, while an unstable one may signify a highly competitive market with limited ability to control prices.
- The competitive dynamics of an industry can be greatly influenced by its stage in the life cycle, making it crucial to consider this when conducting a strategic analysis. Similar to individual companies, industries also go through periods of evolution and often undergo notable fluctuations in growth and profitability. Just as monitoring is necessary for investments in individual companies, industry analysis should be an ongoing process to detect any changes that may be taking place.
An industry life-cycle model, such as the one proposed by Hill and Jones, can be a valuable tool in examining the development of an industry. This model outlines the successive phases that an industry typically experiences, consisting of five distinct stages.
The term embryonic refers to something that is in an early or undeveloped stage.
Expansion;
Trembling;
developed; and
Decrease.
The analysis of an industry often disregards the significance of price competition and adopting a customer’s perspective. The elements that have the greatest impact on customer buying choices are also expected to be the primary focus of competitive competition within the industry. In general, industries where price plays a major role in customer purchasing decisions are typically more competitive compared to industries where customers place higher importance on other attributes.
Factors outside of the industry can impact its growth, profitability, and risk, such as:
The use of technology is crucial in today’s world.
population characteristics;
The ruling authority; and
Factors related to society.
The process of company analysis occurs once the analyst has comprehended the external environment of the company. This involves addressing inquiries regarding the company’s reaction to the challenges and prospects presented by the external environment. This planned response is known as the company’s competitive strategy. The analyst should strive to identify whether the strategy is predominantly defensive or aggressive in nature and the company’s approach to executing it.
According to Porter, there are two main competitive strategies.
A cost-saving approach, known as cost leadership, is implemented by businesses in their pursuit to become the most affordable producers and capture a larger market share by providing their offerings at lower costs compared to their rivals, all while maintaining a profitable margin that results in a higher return on investment due to increased revenue.
*A strategy of differentiating products or services involves companies striving to position themselves as the providers or creators of distinct offerings, whether in terms of quality, category, or method of delivery. For this approach to be effective, the companies must be able to charge higher prices that cover the costs of differentiation, while also ensuring that the differentiated aspects are attractive to customers and can be maintained in the long run.
One component of conducting a company analysis is completing a comprehensive examination of:
Company Overview;
Characteristics of the industry;
The need for goods and services;
provision of goods and services;
cost; and
Ratios in finance.
The use of spreadsheet modeling for financial statements has become a popular method for analyzing and predicting revenue, operating and net income, and cash flows in company analysis. This tool can be utilized to measure the impact of altering key factors on the different financial statements. However, it is important for the analyst to note that the results of the model will heavily rely on the assumptions that are made.
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The amount of 1.75 Polish zloty (PL) is being discussed.
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