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2023 Curriculum CFA Program Level I Equity Investments

Introduction to Industry and Company Analysis

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Introduction

Understanding how industries and companies operate, together with an analysis of financial statements, provides a basis for forecasting company performance and allows analysts to determine the value of an investment in a company or its securities. Industry analysis is the analysis of a specific branch of manufacturing, service, or trade. Understanding the industry in which a company operates provides an essential framework for the analysis of the individual company—that is, company analysis. Equity analysis and credit analysis are often conducted by analysts who concentrate on one or several industries, which results in synergies and efficiencies in gathering and interpreting information.

In this reading, we will address the following questions:

  • 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?
  • How should an analyst approach research and analysis of new industries?
  • What are the factors that influence individual companies?

Learning Outcomes

The member should be able to:

  • explain uses of industry analysis and the relation of industry analysis to company analysis;
  • compare methods by which companies can be grouped;
  • 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”;
  • describe current industry classification systems, and identify how a company should be classified, given a description of its activities and the classification system;
  • 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 thorough industry analysis;
  • describe the principles of strategic analysis of an industry;
  • explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price competition;
  • 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;
  • describe macroeconomic, technological, demographic, governmental, social, and environmental influences on industry growth, profitability, and risk;
  • compare characteristics of representative industries from the various economic sectors;
  • describe the elements that should be covered in a thorough company analysis.

Summary

In this reading, we have provided an overview of industry analysis and illustrated approaches that are widely used by analysts to examine an industry.

  • 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.

  • Examining the market share stability of an industry over time is similar to thinking about barriers to entry and the frequency with which new players enter an industry. Stable market shares typically indicate less competitive industries, whereas unstable market shares often indicate highly competitive industries with limited pricing power.

  • An industry’s position in its life cycle often has a large impact on its competitive dynamics, so it is important to keep this positioning in mind when performing strategic analysis of an industry. Industries, like individual companies, tend to evolve over time and usually experience significant changes in the rate of growth and levels of profitability along the way. Just as an investment in an individual company requires careful monitoring, industry analysis is a continuous process that must be repeated over time to identify changes that may be occurring.

  • A useful framework for analyzing the evolution of an industry is an industry life-cycle model, which identifies the sequential stages that an industry typically goes through. The five stages of an industry life cycle according to the Hill and Jones model are:

    • embryonic;

    • growth;

    • shakeout;

    • mature; and

    • decline.

  • Price competition and thinking like a customer are important factors that are often overlooked when analyzing an industry. Whatever factors most influence customer purchasing decisions are also likely to be the focus of competitive rivalry in the industry. Broadly, industries for which price is a large factor in customer purchase decisions tend to be more competitive than industries in which customers value other attributes more highly.

  • External influences on industry growth, profitability, and risk include:

    • technology;

    • demographics;

    • government; and

    • social factors.

  • Company analysis takes place after the analyst has gained an understanding of the company’s external environment and includes answering questions about how the company will respond to the threats and opportunities presented by the external environment. This intended response is the individual company’s competitive strategy. The analyst should seek to determine whether the strategy is primarily defensive or offensive in its nature and how the company intends to implement it.

  • Porter identifies two chief competitive strategies:

    • A low-cost strategy (cost leadership) is one in which companies strive to become the low-cost producers and to gain market share by offering their products and services at lower prices than their competition while still making a profit margin sufficient to generate a superior rate of return based on the higher revenues achieved.

    • A product/service differentiation strategy is one in which companies attempt to establish themselves as the suppliers or producers of products and services that are unique either in quality, type, or means of distribution. To be successful, the companies’ price premiums must be above their costs of differentiation and the differentiation must be appealing to customers and sustainable over time.

  • A checklist for company analysis includes a thorough investigation of:

    • corporate profile;

    • industry characteristics;

    • demand for products/services;

    • supply of products/services;

    • pricing; and

    • financial ratios.

  • Spreadsheet modeling of financial statements to analyze and forecast revenues, operating and net income, and cash flows has become one of the most widely used tools in company analysis. Spreadsheet modeling can be used to quantify the effects of the changes in certain swing factors on the various financial statements. The analyst should be aware that the output of the model will depend significantly on the assumptions that are made.