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MBA 8480 - Industry Analysis
- 1. Industry Analysis* Professor MikePagano michael.pagano@villanova.edu * - These slides are adapted / excerpted from some of the CFA Institute’s material on this topic.1
- 2. Uses of IndustryAnalysis Understanding a company’s business and business environment Identifying active equity investment opportunities Portfolio performance attribution 2
- 3. Approaches to IdentifyingSimilar Companies Industry Classification Products and/or Services Supplied Business-Cycle Sensitivities Statistical Similarities 3
- 4. Cyclical and NoncyclicalCompanies Profits strongly correlated with economic activity Expensive or non-essential products (discretionary or ‘luxury’) High operating leverage Cyclical Company 4
- 5. Limitations of Industryand Company Descriptors Growth Companies Cyclical Industries Defensive Industries Growth Industries 5
- 6. Commercial Industry ClassificationSystems Global Industry Classification Standard (GICS) Russell Global Sectors (RGS) Industry Classification Benchmark (ICB) 6
- 7. Governmental Industry ClassificationSystems International Standard Industrial Classification of All Economic Activities (ISIC) Statistical Classification of Economic Activities in the European Community (NACE) Australian and New Zealand Standard Industrial Classification (ANZSIC) North American Industry Classification System (NAICS) 7
- 8. Representative Industry Sectors BasicMaterials and Processing Consumer Discretionary Energy Financial Services Industrial/Producer Durables Technology Telecommunications Utilities 8
- 9. Constructing a PeerGroup Examine commercial classification systems Review company’s annual report Review competitors’ annual reports Review industry trade publications Compare business activities 9
- 10. Framework for IndustryAnalysis A Framework for Industry Analysis Economic Sector Customer Bargaining Forces (affected by number of suppliers, number of purchasers, their size/power, switching costs to other suppliers, number of contracted suppliers, customers’ ability to produce the product themselves) Supplier Bargaining Forces (affected by number of industries buying suppliers’ products, of supply substitutes, switching costs of suppliers’ customers, industry, and customers’ ability to enter industry.) Technological Influences Social Influences Macroeconomic Influences (stage of business cycle, longer term growth, and structural economic trends) Demographic Influences Governmental Influences (regulatory, political, legal) Product / Service Substitution Threats New Entrant Threats Group of Complementary Industries Industry Internal Competitive Forces (affected by economies of scale, cost advantages, other brand loyalty, customers’ switching costs, product government regulation, industry’s competitive structure, corporate rivalries, cost conditions, entry and exit barriers) Life Cycle Analysis (embryonic, growth, shake-out, mature, declining) Business Cycle Sensitivity (cyclical: leading, lagging, coincident; defensive, growth) Analysis by Position on the Experience Curve 10
- 11. Strategic Analysis: Porter’s“Five Forces” Intensity of Rivalry Bargaining Power of Customers Threat of New Entrants Threat of Substitute Products Bargaining Power of Suppliers First focus for analysis 11
- 12. Evaluating the Threatof New Entrants and the Level of Competition What are the barriers to entry? How concentrated is the industry? What are capacity levels? How stable are market shares? Where is the industry in its life cycle? How important is price to the customer’s purchase decision? 12
- 13. Barriers to Entry Sustainable Economic Profits Potentialfor Greater Pricing Power High Barriers to Entry 13
- 14. Industry Concentration ABC Company XYZ Company MNO Company What percentageof the market does each of the largest players have? 14
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- 17. Industry Life Cycle Source:Based on Figure 2.4 in Hill and Source: Based on Figure 2.4 in Hill and Jones (2008). Source: Based on Figure 2.4 in Hill and Jones (2008). 17
- 18. Limitations of IndustryLife-Cycle Analysis Technological Changes Regulatory Changes Social Changes Demographic Changes 18
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- 20. Macroeconomic Influences onIndustry Growth, Profitability, and Risk Industry Growth, Profitability, and Risk Economic Growth Interest Rates Availability of Credit Inflation 20
- 21. Other Influences onGrowth, Profitability, and Risk • Invention of the microchip • Digital imaging Examples of Technological Influences • Baby Boomer generation • Aging populations Examples of Demographic Influences • Tax policies and government spending • Regulation Examples of Governmental Influences • Changes in tobacco consumption • Women in the workforce Examples of Social Influences 21
- 22. Industry Analysis forBranded Pharmaceuticals Major Companies Pfizer, Novartis, Merck, GlaxoSmithKline Barriers to Entry/Success Very High: Substantial financial and intellectual capital required to compete effectively. A potential new entrant would need to create a sizable R&D operation, a global distribution network, and large-scale manufacturing capacity. Level of Concentration Concentrated: A small number of companies control the bulk of the global market for branded drugs. Recent mergers have increased the level of concentration. Impact of Industry Capacity Not applicable: Pharmaceutical pricing is primarily determined by patent protection and regulatory issues, including government approval of drugs and manufacturing facilities. Manufacturing capacity is of little importance. Industry Stability Stable: The branded pharmaceutical market is dominated by major companies and consolidation via mega-mergers. Market shares shift quickly, however, as new drugs are approved and gain acceptance or lose patent protection. Life Cycle Mature: Overall demand does not change greatly from year to year. Price Competition Low/Medium: In the United States, price is a minimal factor because of the consumer- and provider-driven, deregulated health care system. Price is a larger part of the decision process in single-payer systems, where efficacy hurdles are higher. Demographic Influences Positive: Populations of developed markets are aging, which slightly increases demand. Government & Regulatory Influences Very High: All drugs must be approved for sale by national safety regulators. Patent regimes may differ among countries. Also, health care is heavily regulated in most countries. Social Influences Not applicable. Technological Influences Medium/High: Biologic (large-molecule) drugs are pushing new therapeutic boundaries, and many large pharmaceutical companies have a relatively small presence in biotech. Growth vs. Defensive vs. Cyclical Defensive: Demand for most health care services does not fluctuate with the economic cycle, but demand is not strong enough to be considered “growth.” 22
- 23. Industry Analysis forOil Services Major Companies Schlumberger, Baker Hughes, Halliburton Barriers to Entry/Success Medium: Technological expertise is required, but a high level of innovation allows niche companies to enter the industry and compete in specific areas. Level of Concentration Fragmented: Although only a small number of companies provide a full range of services, many smaller players compete effectively in specific areas. Service arms of national oil companies may control significant market share in their own countries, and some product lines are concentrated in the mature U.S. market. Impact of Industry Capacity Medium/High: Demand can fluctuate quickly depending on commodity prices, and industry players often find themselves with too few (or too many) employees on the payroll. Industry Stability Unstable: Market shares may shift frequently depending on technology offerings and demand levels. Life Cycle Mature: Demand does fluctuate with energy prices, but normalized revenue growth is only mid-single digits. Price Competition High: Price is a major factor in purchasers’ decisions. Some companies have modest pricing power because of a wide range of services or best-in-class technology, but primary customers (major oil companies) can usually substitute with in-house services if prices are too high. Also, innovation tends to diffuse quickly throughout the industry. Demographic Influences Not applicable. Government & Regulatory Influences Medium: Regulatory frameworks can affect energy demand at the margin. Also, governments play an important role in allocating exploration opportunities to E&P companies, which can indirectly affect the amount of work flowing down to service companies. Social Influences Not applicable. Technological Influences Medium/High: Industry is reasonably innovative, and players must re-invest in R&D to remain competitive. Temporary competitive advantages are possible via commercialization of new processes or exploitation of accumulated expertise. Growth vs. Defensive vs. Cyclical Cyclical: Demand is highly variable and depends on oil prices, exploration budgets, and the economic cycle. 23
- 24. Industry Analysis forConfections/Candy Major Companies Cadbury, Hershey, Mars/Wrigley, Nestle Barriers to Entry/Success Very High: Low financial or technological hurdles, but new players would lack the established brands that drive consumer purchase decisions. Level of Concentration Very Concentrated: Top four companies have a large proportion of global market share. Recent mergers have increased the level of concentration. Impact of Industry Capacity Not applicable: Pricing is driven primarily by brand strength. Manufacturing capacity has little effect. Industry Stability Very Stable: Market shares change glacially. Life Cycle Very Mature: Growth is driven by population trends and pricing. Price Competition Low: A lack of private-label competition keeps pricing stable among established players, and brand/familiarity plays a much larger role in consumer purchase decisions than price. Demographic Influences Not applicable. Government & Regulatory Influences Low: Industry is not regulated, but childhood obesity concerns in developed markets are a low-level potential threat. Also, high-growth emerging markets may block entry of established players into their markets, possibly limiting growth. Social Influences Not applicable. Technological Influences Very Low: Innovation does not play a major role in the industry. Growth vs. Defensive vs. Cyclical Defensive: Demand for candy and gum is extremely stable. 24
- 25. Porter: Competitive Strategy Cost Leadership Differentiation CostFocus Differentiation Focus Scope NarrowBroad Source of Competitive Advantage Cost Differentiation 25
- 26. Company Analysis Provide acompany profile Explain relevant industry characteristics Analyze demand Analyze supply and input costs Explain the pricing environment Present and interpret relevant financial ratios 26
- 27. Decomposition of ROE(DuPont ratios) Net Profit Margin Asset Turnover Financial Leverage ROE 27
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- 29. Summary • Uses ofindustry analysis • Industry classification systems • Establishing a peer group • Strategic analysis: Porter’s five forces • Industry and product life cycles • Demographic, governmental, social, and technological influences • Company analysis • Cost and differentiation strategies • Spreadsheet modeling 29
Editor's Notes
- #3 LOS: Explain the uses of industry analysis and the relation of industry analysis to company analysis. Pages 370-371 Industry analysis is useful in a number of investment applications that make use of fundamental analysis. Its uses include the following: • Understanding a company’s business and business environment. Industry analysis is often a critical early step in stock selection and valuation because it provides insights into the issuer’s growth opportunities, competitive dynamics, and business risks. For a credit analyst, industry analysis provides insights into the appropriateness of a company’s use of debt financing and into its ability to meet its promised payments during economic contractions. • Identifying active equity investment opportunities. Investors taking a top-down investing approach use industry analysis to identify industries with positive, neutral, or negative outlooks for profitability and growth. Generally, investors will then overweight, market weight, or underweight those industries (as appropriate to their outlooks) relative to the investor’s benchmark if the investor judges that the industry’s perceived prospects are not fully incorporated in market prices. Apart from security selection, some investors attempt to outperform their benchmarks by industry or sector rotation—that is, timing investments in industries in relation to an analysis of industry fundamentals and/or business-cycle conditions (technical analysis may also play a role in such strategies). Several studies have underscored the importance of industry analysis by suggesting that the industry factor in stock returns is at least as important as the country factor. In addition, industry membership has been found to account for about 20% of the variability of a company’s profitability in the United States. • Portfolio performance attribution. Performance attribution, which addresses the sources of a portfolio’s returns usually in relation to the portfolio’s benchmark, includes industry or sector selection. Industry classification schemes play a role in such performance attribution.
- #4 LOS: Compare and contrast the 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. Pages 371-374 Modern classification schemes are most commonly based on grouping companies by similar products and/or services. According to this perspective, an industry is defined as a group of companies offering similar products and/or services. For example, major companies in the global heavy truck industry include Volvo, Daimler AG, Paccar, and Navistar, all of which make large commercial vehicles for the on-highway truck market. Similarly, some of the large players in the global automobile industry are Toyota, General Motors, Volkswagen, Ford, Honda, Nissan, PSA Peugeot Citroën, and Hyundai, all of which produce light vehicles that are close substitutes for one another. Companies are sometimes grouped on the basis of their relative sensitivity to the business cycle. This method often results in two broad groupings of companies―cyclical and noncyclical. A cyclical company is one whose profits are strongly correlated with the strength of the overall economy. Such companies experience wider-than-average fluctuations in demand—high demand during periods of economic expansion and low demand during periods of economic contraction—and/or are subject to greater-than-average profit variability related to high operating leverage (i.e., high fixed costs). Concerning demand, cyclical products and services are often relatively expensive and/or represent purchases that can be delayed if necessary (e.g., because of declining disposable income). Examples of cyclical industries are autos, housing, basic materials, industrials, and technology. A noncyclical company is one whose performance is largely independent of the business cycle. Noncyclical companies produce goods or services for which demand remains relatively stable throughout the business cycle. Examples of noncyclical industries are food and beverage, household and personal care products, health care, and utilities. Statistical approaches to grouping companies are typically based on the correlations of past securities’ returns. For example, using the technique known as cluster analysis, companies are separated (on the basis of historical correlations of stock returns) into groups in which correlations are relatively high but between which correlations are relatively low. This method of aggregation often results in nonintuitive groups of companies, and the composition of the groups may vary significantly by time period and region of the world.
- #5 LOS: 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.” Pages 372-374 Examples of cyclical industries are autos, housing, basic materials, industrials, and technology. A noncyclical company is one whose performance is largely independent of the business cycle. Noncyclical companies produce goods or services for which demand remains relatively stable throughout the business cycle. Examples of noncyclical industries are food and beverage, household and personal care products, health care, and utilities.
- #6 LOS: 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.” Pages 372-373 The usefulness of industry and company labels such as “cyclical,” “growth,” and “defensive” is limited. Cyclical industries as well as growth industries often have growth companies within them. A cyclical industry itself, although exposed to the effects of fluctuations in overall economic activity, may grow at an above-average rate for periods spanning multiple business cycles. Furthermore, when fluctuations in economic activity are large, as in the deep recession of 2008−2009, few companies escape the effects of the cyclical weakness in overall economic activity. The defensive label is also problematic. Industries may include both companies that are growth and companies that are defensive in character, making the choice between a “growth” and a “defensive” label difficult. Moreover, “defensive” cannot be understood as necessarily being descriptive of investment characteristics. Food supermarkets, for example, would typically be described as defensive but can be subject to profit-damaging price wars. So-called defensive industries/companies may sometimes face industry dynamics that make them far from defensive in the sense of preserving shareholders’ capital.
- #7 LOS: Compare and contrast the 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. Pages 374-375 GICS was jointly developed by Standard & Poor’s and MSCI Barra, two of the largest providers of global equity indices, in 1999. As the name implies, GICS was designed to facilitate global comparisons of industries, and it classifies companies in both developed and developing economies. Each company is assigned to a subindustry according to its principal business activity. Each subindustry belongs to a particular industry, each industry belongs to an industry group, and each group belongs to a sector. In June 2009, the GICS classification structure comprised four levels of detail consisting of 154 subindustries, 68 industries, 24 industry groups, and 10 sectors. The composition of GICS has historically been adjusted over time to reflect changes in the global equity markets. The RGS classification system uses a three-tier structure to classify companies globally on the basis of the products or services a company produces. In June 2009, the RGS classification system consisted of 9 sectors, 32 subsectors, and 141 industries. Besides the number of tiers, another difference between the RGS and GICS classification systems is that the RGS system contains 9 sectors whereas GICS consists of 10. For example, the RGS system does not provide a separate sector for telecommunication service companies. Many companies that GICS classifies as “Telecommunication Services,” including China Mobile Ltd., AT&T, and Telefonica, are assigned by RGS to its more broadly defined “Utilities” sector. The ICB, which was jointly developed by Dow Jones and FTSE, uses a four-tier structure to categorize companies globally on the basis of the source from which a company derives the majority of its revenue. In June 2009, the ICB classification system consisted of 10 industries, 19 supersectors, 41 sectors, and 114 subsectors. Although the ICB is similar to GICS in the number of tiers and the method by which companies are assigned to particular groups, the two systems use significantly different nomenclature. For example, GICS uses the term “sector” to describe its broadest grouping of companies, whereas the ICB uses the term “industry.” Another difference among the systems is that the ICB distinguishes between consumer goods and consumer services companies whereas both GICS and the RGS system group consumer products companies and consumer services companies together into sectors on the basis of economic sensitivity. These stylistic distinctions tend to be less obvious at the more granular levels of the different hierarchies.
- #8 LOS: Compare and contrast the 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. Pages 378-379 The International Standard Industrial Classification of All Economic Activities (ISIC) was adopted by the United Nations in 1948 to address the need for international comparability of economic statistics. ISIC classifies entities into various categories on the basis of the principal type of economic activity the entity performs. ISIC is organized into 11 categories, 21 sections, 88 divisions, 233 groups, and more than 400 classes. According to the United Nations, a majority of countries around the world have either used ISIC as their national activity classification system or have developed national classifications derived from ISIC. Some of the organizations currently using the ISIC are the UN and its specialized agencies, the International Monetary Fund, the World Bank, and other international bodies. Often regarded as the European version of ISIC, Statistical Classification of Economic Activities in the European Community (NACE) is the classification of economic activities that correspond to ISIC at the European level. Similar to ISIC, NACE classification is organized according to economic activity. NACE is composed of four levels—namely, sections (identified by alphabetical letters A through U), divisions (identified by two-digit numerical codes 01 through 99), groups (identified by three-digit numerical codes 01.1 through 99.0), and classes (identified by four-digit numerical codes 01.11 through 99.00). The Australian and New Zealand Standard Industrial Classification (ANZSIC) was jointly developed by the Australian Bureau of Statistics and Statistics New Zealand in 1993 to facilitate the comparison of industry statistics of the two countries and comparisons with the rest of the world. International comparability was achieved by aligning ANZSIC with the international standards used by ISIC. ANZSIC has a structure comprising five levels—namely, divisions (the broadest level), subdivisions, groups, classes, and at the most granular level, subclasses (New Zealand only). Jointly developed by the United States, Canada, and Mexico, the North American Industry Classification System (NAICS) replaced the Standard Industrial Classification (SIC) system in 1997. NAICS distinguishes between establishments and enterprises. NAICS classifies establishments into industries according to the primary business activity of the establishment. In the NAICS system, an establishment is defined as a single physical location where business is conducted or where services or industrial operations are performed (e.g., factory, store, hotel, movie theater, farm, office). An enterprise may consist of more than one location performing the same or different types of economic activities. Each establishment of that enterprise is assigned a NAICS code on the basis of its own primary business activity. NAICS uses a two-digit through six-digit code to structure its categories into five levels of detail. The greater the number of digits in the code, the more narrowly defined the category. The five levels of categories, from broadest to narrowest, are sector (signified by the first two digits of the code), subsector (third digit of the code), industry group (fourth digit), NAICS industry (fifth digit), and national industry (sixth digit). The five-digit code is the level of greatest amount of comparability among countries; a six-digit code provides for more country-specific detail.
- #9 LOS: Compare and contrast the 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. Pages 375-376 Basic Materials and Processing—companies engaged in the production of building materials, chemicals, paper and forest products, containers and packaging, and metal, mineral, and mining companies. Consumer Discretionary—companies that derive a majority of revenue from the sale of consumer-related products or services for which demand tends to exhibit a relatively high degree of economic sensitivity. Examples of business activities that frequently fall into this category are automotive, apparel, hotel, and restaurant businesses. Consumer Staples—consumer-related companies whose business tends to exhibit less economic sensitivity than other companies; for example, manufacturers of food, beverage, tobacco, and personal care products. Energy—companies whose primary line of business involves the exploration, production, or refining of natural resources used to produce energy; companies that derive a majority of revenue from the sale of equipment or through the provision of services to energy companies would also fall into this category. Financial Services—companies whose primary line of business involves banking, finance, insurance, real estate, asset management, and/or brokerage services. Health Care—manufacturers of pharmaceutical and biotech products, medical devices, health care equipment, and medical supplies and providers of health care services. Industrial/Producer Durables—manufacturers of capital goods and providers of commercial services; for example, business activities would include heavy machinery and equipment manufacture, aerospace and defense, transportation services, and commercial services and supplies. Technology—companies involved in the manufacture or sale of computers, software, semiconductors, and communications equipment; other business activities that frequently fall into this category are electronic entertainment, internet services, and technology consulting and services. Telecommunications—companies that provide fixed-line and wireless communication services; some vendors prefer to combine telecommunication and utility companies together into a single “utilities” category. Utilities—electric, gas, and water utilities; telecommunication companies are sometimes included in this category.
- #10 LOS: Explain the relation of “peer group,” as used in equity valuation, to a company’s industry classification. Pages 380-381 A peer group is a group of companies engaged in similar business activities whose economics and valuation are influenced by closely related factors. Comparisons of a company in relation to a well-defined peer group can provide valuable insights into the company’s performance and its relative valuation. The following are steps in constructing a preliminary list of peer companies: • Examine commercial classification systems, if available to the analyst. 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 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.
- #11 LOS: Discuss the elements that need to be covered in a thorough industry analysis. Pages 385-387 Exhibit 9-2 provides a framework designed to help analysts check that they have considered the range of forces that may affect the evolution of an industry. It shows, at the macro level, macroeconomic, demographic, governmental, social, and technological influences affecting the industry. It then depicts how an industry is affected by the forces driving industry competition (threat of new entrants, substitution threats, customer and supplier bargaining forces), the competitive forces in the industry, life-cycle issues, business-cycle considerations, and the position of the industry on the experience curve.
- #12 LOS: Discuss the principles of strategic analysis of an industry. Pages 386-388 Analysis of the competitive environment with an emphasis on the implications of the environment for corporate strategy is known as strategic analysis. Michael Porter’s “five forces” framework is the classic starting point for strategic analysis. Porter focused on five determinants of the intensity of competition in an industry: • The threat of substitute products, which can negatively affect demand if customers choose other ways of satisfying their needs. For example, consumers may trade down from premium beers to discount brands during recessions. Low-priced brands may be close substitutes for premium brands, which, when consumer budgets are constrained, reduces the ability of premium brands to maintain or increase prices. • The bargaining power of customers, which can affect the intensity of competition by exerting influence on suppliers regarding prices (and possibly other factors, such as product quality). For example, auto parts companies generally sell to a small number of auto manufacturers, which allows those customers, the auto manufacturers, to be tough negotiators when it comes to setting prices. • The bargaining power of suppliers, which may be able to raise prices or restrict the supply of key inputs to a company. For example, workers at a heavily unionized company may have greater bargaining power as suppliers of labor than workers at a comparable nonunionized company. Suppliers of scarce or limited parts or elements often possess significant pricing power. • The threat of new entrants to the industry, which depends on barriers to entry, or how difficult it would be for new competitors to enter the industry. Industries that are easy to enter will generally be more competitive than industries with high barriers to entry. • The intensity of rivalry among incumbent companies (i.e., the current companies in the industry), which is a function of the industry’s competitive structure. Industries that are fragmented among many small competitors, have high fixed costs, provide undifferentiated (commodity-like) products, or have high exit barriers usually experience more intense rivalry than industries without these characteristics.
- #13 LOS: Discuss the principles of strategic analysis of an industry. Page 389 Addressing the following questions should help the analyst evaluate the threat of new entrants and the level of competition in an industry and thereby provide an effective base for describing and analyzing the industry: • What are the barriers to entry? Is it difficult or easy for a new competitor to challenge incumbents? Relatively high (low) barriers to entry imply that the threat of new entrants is relatively low (high). • How concentrated is the industry? Do a small number of companies control a relatively large share of the market, or does the industry have many players, each with a small market share? • What are capacity levels? That is, 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 undercapacity, 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 it demand stagnant/declining? • How important is price to the customer’s purchase decision?
- #14 LOS: Explain the effects of industry concentration, ease of entry, and capacity on return on invested capital and pricing power. Pages 389-391 When a company is earning economic profits, the chances that it will be able to sustain them through time are greater, all else being equal, if the industry has high barriers to entry. The ease with which new competitors can challenge incumbents is often an important factor in determining the competitive landscape of an industry. If new competitors can easily enter the industry, the industry is likely to be highly competitive because high returns on invested capital will quickly be competed away by new entrants eager to grab their share of economic profits. As a result, industries with low barriers to entry often have little pricing power because price increases that raise companies’ returns on capital will eventually attract new competitors to the industry. Companies earning economic profits are achieving returns on investment above the opportunity cost of funds.
- #15 LOS: Explain the effects of industry concentration, ease of entry, and capacity on return on invested capital and pricing power. Pages 391-394 Much like industries with barriers to entry, industries that are concentrated among a relatively small number of players often experience relatively less price competition. An analysis of industry concentration should start with market share: What percentage of the market does each of the largest players have, and how large are those shares relative to each other and relative to the remainder of the market? Often, the relative market shares of competitors matter as much as their absolute market shares. Fragmented industries tend to be highly price competitive for several reasons. First, the large number of companies makes coordination difficult because there are too many competitors for each industry member to monitor effectively. Second, each player has such a small piece of the market that even a small gain in market share can make a meaningful difference to its fortunes, which increases the incentive of each company to undercut prices and attempt to steal share. Finally, the large number of players encourages industry members to think of themselves individualistically rather than as members of a larger group, which can lead to fierce competitive behavior.
- #16 LOS: Explain the effects of industry concentration, ease of entry, and capacity on return on invested capital and pricing power. Pages 394-396 The effect on pricing of industry capacity (the maximum amount of a good or service that can be supplied in a given time period) is clear: Tight, or limited, capacity gives participants more pricing power as demand for the product or service exceeds supply, whereas overcapacity leads to price cutting and a very competitive environment as excess supply chases demand. An analyst should think about not only current capacity conditions but also future changes in capacity levels. How quickly can companies in the industry adjust to fluctuations in demand? How flexible is the industry in bringing supply and demand into balance? What will be the effect of that process on industry pricing power or on industry margins?
- #17 LOS: Explain the effects of industry concentration, ease of entry, and capacity on return on invested capital and pricing power. Pages 396-397 Examining the stability of industry market shares over time is similar to thinking about barriers to entry and the frequency with which new players enter an industry. In fact, barriers to entry and the frequency of new product introductions, together with such factors as product differentiation, all affect market shares. Stable market shares typically indicate less competitive industries; unstable market shares often indicate highly competitive industries that have limited pricing power.
- #18 LOS: Describe product and industry life-cycle models, classify an industry as to life-cycle phase (e.g., embryonic, growth, shakeout, maturity, or decline) based on a description of it, and discuss the limitations of the life-cycle concept in forecasting industry performance. Pages 397-400 The five stages of an industry life-cycle model are embryonic, growth, shakeout, mature, and decline. Each stage is characterized by different opportunities and threats. Embryonic—An embryonic industry is one that is just beginning to develop. Characteristics of the embryonic stage include slow growth and high prices because customers tend to be unfamiliar with the industry’s product and volumes are not yet sufficient to achieve meaningful economies of scale. Increasing product awareness and developing distribution channels are key strategic initiatives of companies during this stage. Substantial investment is generally required, and the risk of failure is high. Growth—A growth industry tends to be characterized by rapidly increasing demand, improving profitability, falling prices, and relativity low competition among companies in the industry. Demand is fueled by new customers entering the market, and prices fall as economies of scale are achieved and as distribution channels develop. The threat of new competitors entering the industry is usually highest during the growth stage, when barriers to entry are relatively low. Competition tends to be relatively limited, however, because rapidly expanding demand provides companies with an opportunity to grow without needing to capture market share from competitors. Industry profitability improves as volumes rise and economies of scale are attained. Shakeout—The shakeout stage is usually characterized by slowing growth, intense competition, and declining profitability. During the shakeout stage, demand approaches market saturation levels because few new customers are left to enter the market. Competition is intense as growth becomes increasingly dependent on market share gains. Excess industry capacity begins to develop as the rate at which companies continue to invest exceeds the overall growth of industry demand. In an effort to boost volumes to fill excess capacity, companies often cut prices, so industry profitability begins to decline. During the shakeout stage, companies increasingly focus on reducing their cost structure (restructuring) and building brand loyalty. Marginal companies may fail or merge with others. Mature—Characteristics of a mature industry include little or no growth, industry consolidation, and relatively high barriers to entry. Industry growth tends to be limited to replacement demand and population expansion because the market at this stage is completely saturated. As a result of the shakeout, mature industries often consolidate and become oligopolies. The surviving companies tend to have brand loyalty and relatively efficient cost structures, both of which are significant barriers to entry. During periods of stable demand, companies in mature industries tend to recognize their interdependence and try to avoid price wars. Periodic price wars do occur, however, most notably during periods of declining demand (such as during economic downturns). Companies with superior products or services are likely to gain market share and experience above-industry-average growth and profitability. Decline—during the decline stage, industry growth turns negative, excess capacity develops, and competition increases. Industry demand at this stage may decline for a variety of reasons, including technological substitution. As demand falls, excess capacity in the industry forms and companies respond by cutting prices, which often leads to price wars. At this point, the weaker companies often exit the industry, merge, or redeploy capital into different products and services.
- #19 LOS: Describe product and industry life-cycle models, classify an industry as to life-cycle phase (e.g., embryonic, growth, shakeout, maturity, or decline) based on a description of it, and discuss the limitations of the life-cycle concept in forecasting industry performance. Pages 400-401 Although models can provide a useful framework for thinking about an industry, the evolution of an industry does not always follow a predictable pattern. Various external factors may significantly affect the shape of the pattern, causing some stages to be longer or shorter than expected and, in certain cases, causing some stages to be skipped altogether. Technological changes may cause an industry to experience an abrupt shift from growth to decline, thus skipping the shakeout and mature stages. For example, the movie rental industry is experiencing rapid change as consumers increasingly turn to on-demand services, such as downloading movies from the internet or through their cable providers. Regulatory changes can also have a profound impact on the structure of an industry. A prime example is the deregulation of the U.S. telecommunications industry in the 1990s, which transformed a monopolistic industry into an intensely competitive one. Social changes also have the ability to affect the profile of an industry. The casual dining industry has benefited over the past 30 years from the increase in the number of dual-income families, who often have more income but less time to cook meals to eat at home. Demographics also play an important role. As the Baby Boomer generation ages, for instance, industry demand for health care services is likely to increase.
- #20 LOS: Explain the effects of industry concentration, ease of entry, and capacity on return on invested capital and pricing power. Page 402 A highly useful tool for analyzing an industry is attempting to think like a customer of the industry. Whatever factor most influences customer purchase decisions is likely to also be the focus of competitive rivalry in the industry. In general, 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.
- #21 LOS: Discuss the elements that need to be covered in a thorough industry analysis. Pages 405-406 Trends in overall economic activity generally have significant effects on the demand for an industry’s products or services. These trends can be cyclical (i.e., related to changes in economic activity caused by the business cycle) or structural (i.e., related to enduring changes in the composition or magnitude of economic activity). Among the economic variables that usually affect an industry’s revenues and profits are the following: • gross domestic product or the measure of the value of goods and services produced by an economy, either in current or constant currency (inflation-adjusted) terms; • interest rates, which represent the cost of debt to consumers and businesses and are important ingredients in financial institutions’ revenues and costs; • the availability of credit, which affects business and consumer spending and financial solvency; and • inflation, which reflects the changes in prices of goods and services and influences costs, interest rates, and consumer and business confidence.
- #22 LOS: Illustrate demographic, governmental, social, and technological influences on industry growth, profitability, and risk. Pages 405-411 New technologies create new or improved products that can radically change an industry and can also change how other industries that use the products conduct their operations. The computer hardware industry provides one of the best examples of how technological change can affect industries. The 1958 invention of the microchip (also known as an “integrated circuit,” which is effectively a computer etched on a sliver of silicon) enabled the computer hardware industry to eventually create a new market of personal computing for the general public and radically extended the use of computers in business, government, and educational institutions. Another example of the effects of technology on an industry is the impact of digital imaging technology on the photographic film industry. Since their invention in 1981, digital cameras have become extremely popular and now widely outsell traditional film cameras (although many professional photographers continue to use film for esthetic reasons for certain applications). Changes in population size, in the distributions of age and gender, and in other demographic characteristics may have significant effects on economic growth and on the amounts and types of goods and services consumed. The effects of demographics on industries are well exemplified by the impact of the post–World War II Baby Boom in North America on demand for goods and services. Born between 1946 and 1964, this bulge of 76 million people in the North American population has influenced the composition of numerous products and services it has needed in its passage from the cradle through childhood, adolescence, early adulthood, middle age, and into retirement. Another example of the effects of demographics on industries is the impact of an aging population in Japan, which has one of the highest percentages of elderly residents (21% over the age of 65) and a very low birth rate. Japan’s ministry of health estimates that by 2055, the percentage of the population over 65 will rise to 40% and the total population will fall by 25%. Governmental influence on industries’ revenues and profits is pervasive and important. In setting tax rates and rules for corporations and individuals, governments affect profits and incomes, which, in turn, affect corporate and personal spending. Governments are also major purchasers of goods and services from a range of industries. Governments exert their influence indirectly by empowering other regulatory or self-regulatory organizations (e.g., stock exchanges, medical associations, utility rate setters, and other regulatory commissions) to govern the affairs of an industry. By setting the terms of entry into various sectors, such as financial services and health care, and the rules that companies and individuals must adhere to in these fields, governments control the supply, quality, and nature of many products and services and the public’s access to them. Societal changes involving how people work, spend their money, enjoy their leisure time, and conduct other aspects of their lives can have significant effects on the sales of various industries. Tobacco consumption in the United Kingdom provides a good example of the effects of social influences on an industry. Although the role of government in curbing tobacco advertising, legislating health warnings on the purchases of tobacco products, and banning smoking in public places (such as restaurants, bars, public houses, and transportation vehicles) probably has been the most powerful apparent instrument of changes in tobacco consumption, the forces underlying that change have really been social in nature—namely, increasing consciousness on the part of the population of the damage to the health of tobacco users and those in their vicinity from smoking, the increasing cost to individuals and governments of the chronic illnesses caused by tobacco consumption, and the accompanying shift in public perception of smokers from socially correct to socially incorrect—even inconsiderate or reckless. In 1870, women accounted for only 15% of the workforce in the United States outside the home. By 1950, after two world wars and the Great Depression, this figure had risen to 30% (it had been even higher temporarily during WWII because of high levels of war-mandated production) and by 2008, to 48%.
- #23 LOS: Compare and contrast the characteristics of representative industries from the various economic sectors. Pages 402-405
- #24 LOS: Compare and contrast the characteristics of representative industries from the various economic sectors. Pages 402-405
- #25 LOS: Compare and contrast the characteristics of representative industries from the various economic sectors. Pages 402-405
- #26 LOS: Describe the elements that should be covered in a thorough company analysis. Pages 412-413 Porter identifies two chief competitive strategies: a low-cost strategy (cost leadership) and a product/service differentiation strategy. In a low-cost strategy, companies strive to become 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. Low-cost strategies may be pursued defensively to protect market positions and returns or offensively to gain market share and increase returns. Pricing also can be defensive (when the competitive environment is one of low rivalry) or aggressive (when rivalry is intense). In the case of intense rivalry, pricing may even become predatory—that is, aimed at rapidly driving competitors out of business at the expense of near-term profitability. The hope in such a strategy is that having achieved a larger market share, the company can later increase prices to generate higher returns than before. For example, the predatory strategy has been alleged by some analysts to have been followed by major airlines trying to protect lucrative routes from discount airlines. Although laws concerning anti-competitive practices often prohibit predatory pricing to gain market share, in most cases, it is difficult to accurately ascribe the costs of products or services with sufficient precision to demonstrate that predatory pricing (as opposed to intense but fair price competition) is occurring. Companies seeking to follow low-cost strategies must have tight cost controls, efficient operating and reporting systems, and appropriate managerial incentives. In addition, they must commit themselves to painstaking scrutiny of production systems and their labor forces and to low-cost designs and product distribution. They must be able to invest in productivity-improving capital equipment and to finance that investment at a low cost of capital. In differentiation strategies, 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, their price premiums must be above their costs of differentiation and the differentiation must be appealing to customers and sustainable over time. Corporate managers who successfully pursue differentiation strategies tend to have strong market research teams to identify and match customer needs with product development and marketing. Such a strategy puts a premium on employing creative and inventive people.
- #27 LOS: Describe the elements that should be covered in a thorough company analysis. Pages 413-416 A thorough company analysis, particularly as presented in a research report, should • provide an overview of the company (corporate profile), including a basic understanding of its businesses, investment activities, corporate governance, and perceived strengths and weaknesses. • explain relevant industry characteristics. • analyze the demand for the company’s products and services. • analyze the supply of products and services, which includes an analysis of costs. • explain the company’s pricing environment. • present and interpret relevant financial ratios, including comparisons over time and comparisons with competitors. Company analysis often includes forecasting the company’s financial statements, particularly when the purpose of the analysis is to use a discounted cash flow method to value the company’s common equity.
- #28 LOS: Describe the elements that should be covered in a thorough company analysis. Page 416 The decomposition of ROE can be used to analyze how and why a company’s ROE differs from that of other companies or its own ROE in other periods by tracing the differences to changes in its profit margin, the productivity of its assets, or its financial leverage. ROE = (Net profit margin: Net earnings/Net sales) × (Asset turnover: Net sales/Average total assets) × (Financial leverage: Average total assets/Average common equity)
- #29 LOS: Describe the elements that should be covered in a thorough company analysis. Pages 416-417 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.