Understanding the Landscape for Better Investment Decisions
Industry analysis provides the essential context for understanding a company's performance and potential. Because companies within the same industry often share similar business models, risks, and profitability drivers, analyzing the industry is a critical step in equity valuation.
Classifying companies into industries groups them with firms that offer similar products or services. However, this process can be challenging due to substitute products, multi-industry companies, and evolving markets.
Analysts may also group companies based on:
A thorough industry survey provides a high-level overview of the industry's health and competitive intensity.
Measure the industry's total annual sales and its historical growth rate. This helps to classify the industry into a growth style box (e.g., Growth vs. Mature, Cyclical vs. Defensive).
Assess the overall profitability using metrics like Return on Invested Capital (ROIC). This reveals the average profitability an analyst can expect from a company in that industry.
Analyze market share trends to identify major players and gauge competitive dynamics. Industry concentration can be measured using the Herfindahl-Hirschman Index (HHI). A higher HHI indicates a more concentrated industry with less competition, which often leads to higher profitability.
This framework is a cornerstone of industry analysis, helping to identify the sources of competitive pressure in an industry. The collective strength of these five forces determines the industry's long-term profit potential.
How easy is it for new competitors to enter the market? High barriers to entry (e.g., high capital requirements, strong brands, regulation) protect incumbent firms and allow for higher profitability.
How easily can customers switch to a different product or service that meets the same need? The availability of close substitutes limits an industry's pricing power.
How much power do buyers have to drive down prices? Power is high when buyers are concentrated, purchase in large volumes, or when products are undifferentiated.
How much power do suppliers have to raise input prices? Power is high when suppliers are concentrated, offer unique resources, or when switching costs are high for the buyers.
How intense is the competition between existing firms in the industry? Rivalry is high when there are many competitors, high fixed costs, or undifferentiated products, which leads to reduced pricing power and profitability.
Beyond the industry structure, broader macro-environmental factors can significantly influence industry growth and profitability. The PESTLE framework helps to analyze these external forces.
Government policies, regulations, and geopolitical events.
GDP growth, inflation, interest rates, and exchange rates.
Cultural trends, demographics, and consumer preferences.
Innovations that can create or disrupt industries.
Laws and regulations governing industry practices.
Pressures related to climate change and sustainability.
After analyzing the industry, the final step is to evaluate a specific company's competitive strategy and its position within that industry.
Aiming to become the lowest-cost producer in the industry for a broad market. Defense comes from the high capital requirements and operational efficiency that rivals struggle to match.
Offering unique products or services that are valued by a broad market, allowing the company to command a premium price. Defense comes from brand loyalty and product uniqueness.
Targeting a niche market with either a low-cost or a differentiated offering tailored to that specific segment's needs. Defense comes from deep customer loyalty within the niche.