“Introduction to Industry and Company Analysis” – Chapter 3 from Equity Asset Valuation, 3rd Edition by John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E. Pinto, CFA and Elaine Henry, CFA Synopsis prepared by: Larry A.
Lonis, CFA Revised: 2/2/2017 Table of Contents Introduction Uses of Industry Analysis Approaches to Identifying Similar Companies Products and/or Services Supplied Business-cycle Sensitivities Statistical Similarities Industry Classification Systems Commercial Industry Classification Systems Governmental Industry Classification systems Strengths and Weaknesses of current systems Constructing a Peer Group Describing and Analyzing an Industry Principles of Strategic Analysis External Influences of Industry Growth, Profitability, and Risk Company Analysis Elements That Should be covered in a Company Analysis Spreadsheet Modeling Summary DePaul University - Finance 526 Larry A. Lonis, CFA 2 Learning Outcomes Explain uses of industry analysis and the relation of industry analysis to company analysis. Compare methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system. Explain the factors that affect the sensitivity of a company to the business cycle and the uses and limitations of industry and company descriptors such as “growth,” “defensive,” and “cyclical.” Explain how a company’s industry classification can be used to identify a potential “peer group” for equity valuation.
Describe the elements that need to be covered in a through industry analysis. Describe the principles of strategic analysis of an industry. Explain the effects of barriers to entry, industry concentrations, industry capacity, and market share stability on pricing power and price competition. DePaul University - Finance 526 Larry A.
Lonis, CFA 3 Learning Outcomes Describe industry life cycle models, classify an industry as to life cycle stage, and describe limitations of the life-cycle concept in forecasting industry performance. Compare characteristics of representative industries from the various economic sectors. Describe macroeconomic, technological, demographic, governmental, and social influences on industry growth, profitability, and risk. Describe the elements that should be covered in a thorough company analysis.
DePaul University - Finance 526 Larry A. Lonis, CFA 4 Introduction Key questions to address What are the similarities and differences among industry classification systems? How does an analyst go about choosing a peer group of companies? What are the key factors to consider when analyzing an industry? What advantages are enjoyed by companies in strategically well- positioned industries? DePaul University - Finance 526 Larry A. Lonis, CFA 5 Uses of Industry Analysis Industry analysis is useful in a number of investment applications that make use of fundamental analysis. It uses the following: Understanding a company's business and business environment Identifying active equity investment opportunities Portfolio performance attribution Industry classification attempts to place companies into groups on the basis of commonalities.
Three major approaches to industry classification are: Products and/or services supplied Business-cycle sensitivities Statistical similarities DePaul University - Finance 526 Larry A. Lonis, CFA 6 Approaches to Identifying Similar Companies Examples of classification systems based on products and/or services include the commercial classification systems namely: Global Industry Classification Standard (GICS) Russell Global sectors (RGS) Industry Classification Benchmark Business sensitivity can be either: Cyclical - profits are strongly correlated with the strength of the overall economy. Non-cyclical - a company whose performance is largely independent of the business cycle - demand remains relatively stable through the business cycle. One limitation of the cyclical/non-cyclical classification is that business- cycle sensitivity is a continuous spectrum rather than an either/or issue.
DePaul University - Finance 526 Larry A. Lonis, CFA 7 Industry Classification Systems Commercial Industry Classification Systems – classification by major index providers; MSCI, Standard & Poors, Russell Investments, etc. Global Industry Classification Standard – GICs sector classifications; 154 sub-industries, 68 industries, 24 industry groups, and finally now 11 sectors with the addition of the new REIT sector. Russell Global Sectors – a three tier structure to classify companies globally on the basis of products or services a company produces.
Industry Classification Benchmark – a four-tier structure to categorize companies globally on the basis of the source from which a company derives the majority of its revenue. There are also governmental industry classification systems, European, Australian and New Zealand, North American Industry Classification System. DePaul University - Finance 526 Larry A. Lonis, CFA 8 Industry Classification Systems Strengths and weaknesses of current systems include: Most government systems do not disclose information about a specific business or company so an analyst cannot know all the constituents of a particular category.
Commercial classification systems are adjusted more frequently than government classification systems which may be updated only every five years or so. Government classification systems do not distinguish between: Small and large businesses Between for-profits and not-for-profit organizations Between public and private companies. Commercial classification systems have the ability to make these distinctions by association with a particular equity index. DePaul University - Finance 526 Larry A.
Lonis, CFA 9 Constructing a Peer Group Steps in constructing a preliminary list of companies: Examine commercial classification systems. Review the subject company's annual report for a discussion of the competitive environment. Review competitors annual reports to identify other potential comparable companies. Review industry trade publications to identify comparable companies.
Confirm that each comparable company derives a significant portion of its revenue and operating profit from a business activity similar to the primary business of the subject company. DePaul University - Finance 526 Larry A. Lonis, CFA 10 Constructing a Peer Group Questions that may improve the list of peer companies: What portion of the revenue and operating profit is derived from business activities similar to those of the subject company? Does the potential peer company face a demand environment similar to that of the subject company? Does the potential company have a finance subsidiary? It is important to distinguish between a company's industry as defined by one or more of the various classification systems, and its peer group. A company’s peer group should consist of companies with similar business activities whose economic activity depends on similar drivers of demand and similar factors related to cost structure and access to financial capital.
In practice, out of the necessity this frequently results in a smaller group (even a different group) of companies than the most narrowly defined categories used by the common commercial classification systems. DePaul University - Finance 526 Larry A. Lonis, CFA 11 Describing and Analyzing an Industry Investment managers and analysts also examine industry performance: In relation to other industries to identify industries with superior/ inferior returns Overtime to determine the degree of consistency, stability, and risk in the returns in the industry over time. Criteria for selecting a strategic group might include: Complexity of the product or service Its mode of delivery Barriers to entry DePaul University - Finance 526 Larry A.
Lonis, CFA 12 Describing and Analyzing an Industry The life-cycle stage is often used to classify industries. The curve tends to decline: Because as the utilization of capital equipment increases, fixed costs (administration, overhead, advertising, etc.) are spread over a larger number of units of production. Because improvements in labor efficiency and management of facilities. Because of advances in production methods and product design.
Macroeconomic influences include: Stage of business cycle Longer term growth Structural economic trends DePaul University - Finance 526 Larry A. Lonis, CFA 13 Describing and Analyzing an Industry Supplier bargaining forces include: Number of industries buying suppliers' products Supply substitutes Switching costs of suppliers' customers Industry and customer ability to enter the industry New entrant threats include: Economic Group of complimentary industries Industry Life-cycle analysis stages include: Embryonic Growth Shake-out Mature Declining DePaul University - Finance 526 Larry A. Lonis, CFA 14 Describing and Analyzing an Industry Customer bargaining forces include affected by: Number of suppliers Number of purchasers Size/power of the purchasers Switching costs to other suppliers Number of contracted suppliers Customers ability to produce the product themselves When you assemble these various forces on a macro level you need to evaluate them as: Demographic influences Macroeconomic influences Governmental influences Technological influences Product/service substitution threats Social influences DePaul University - Finance 526 Larry A. Lonis, CFA 15 Describing and Analyzing an Industry Internal competitive forces are affected by: Economies of scale Cost advantages Other brand loyalty Customer's switching costs Product government regulation Industry competitive structure Corporate rivalries Cost conditions Entry and exit barriers DePaul University - Finance 526 Larry A.
Lonis, CFA 16 Five Determinants of Industry Competition Porter identified five determinants of the intensity of competition in an industry: Threat of entry - depends on barriers to entry or how difficult it would be for new competitors to enter the industry. Power of suppliers - they may be able to raise prices or restrict the supply of key inputs to a company. Power of buyers - this can affect the intensity of competition by exerting influence on suppliers regarding prices (and possibly other factors such as product quality). Threat of substitutes - this can negatively affect demand if customers choose other ways of satisfying their needs.
Low price brands can impact premium brands when consumer budgets are constrained. Rivalry among existing competitors - a function of the industry's competitive structure. DePaul University - Finance 526 Larry A. Lonis, CFA 17 Five Determinants of Industry Competition Intense rivalry usually exists when the following characteristics exist: Industries are fragmented among many small competitors.
Have high fixed costs Provide undifferentiated (commodity-like) products, and Have high exit barriers DePaul University - Finance 526 Larry A. Lonis, CFA 18 Assessing the Level of Industry Competition Addressing the following questions should help the analyst evaluate the threat of new entrants and the level of competition in an industry and therefore provide an effective base for describing and analyzing an industry. What are the barriers to entry - difficult or easy for a new competitor to challenge incumbents? How concentrated is the industry - do a small number of competitors control a large share of the market or are their many players each with a small market share. What are capacity levels - based on existing investment, how much of the goods or services can be delivered in a given time frame? Does the industry suffer chronic over-or-under-capacity, or do supply and demand tend to come into balance reasonably quickly in the industry.
How stable are market shares - do companies tend to rapidly gain or lose share, or is the industry stable? Where is the industry in its life-cycle - does it have meaningful growth prospects, or is demand stagnant/declining? How important is price to the customer's purchase decision? DePaul University - Finance 526 Larry A. Lonis, CFA 19 Assessing the Level of Industry Competition High economic profits lead to: Entry of new competitors if high barriers to entry do not exist. If new competitors can easily enter the industry the industry will be highly competitive. High returns on capital can be competed away if new entrants can grab their share of economic profits.
Industries with low barriers often have little pricing power because price increases that raise returns on capital often attract new competitors to the industry.