(40) Introduction to Industry and Company Analysis Flashcards
LOS 49. a: Explain uses of industry analysis and the relation of industry analysis to company analysis. What is industry analysis necessary for?
Industry analysis is necessary for understanding a company’s business environment before engaging in analysis of the company.
LOS 49. a: Explain uses of industry analysis and the relation of industry analysis to company analysis. What information can the industry environment provide?
The industry environment can provide information about the firm’s:
- potential growth
- competition, risks
- appropriate debt levels, and;
- credit risk.
LOS 49. a: Explain uses of industry analysis and the relation of industry analysis to company analysis. What can industry valuation be used for?
Industry valuation can be used in an active management strategy to determine which industries to overweight or underweight in a portfolio.
LOS 49. a: Explain uses of industry analysis and the relation of industry analysis to company analysis. What is industry representation often a component in?
Industry representation is often a component in a performance attribution analysis of a portfolio’s return.
LOS 49. b: 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.
Firms can be grouped into industries according to their products and services or business cycle sensitivity, or through statistical methods that group firms with high historical correlation in returns.
LOS 49. b: 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. What are the industry classification systems from commercial providers?
Industry classification systems from commercial providers include:
- the Global Industry Classification Standard (Standard & Poor’s and MSCI Barra),
- Russell Global Sectors, and;
- Industry Classification Benchmark (Dow Jones and FTSE).
LOS 49. b: 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. What are the industry classification systems from government agencies?
Industry classification systems developed by government agencies include:
- the International Standard Industrial Classification (ISIC)
- the North American Industry Classification System (NAICS), and;
- systems designed for the European Union and Australia/New Zealand.
LOS 49. c: 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”.
A cyclical firm has earnings that are highly dependent on the business cycle.
A non-cyclical firm has earnings that are less dependent on the business cycle.
Industries can also be classified as cyclical or non-cyclical.
Non-cyclical industries or firms can be classified as defensive (demand for the product tends not to fluctuate with the business cycle) or growth (demand is so strong that it is largely unaffected by the business cycle).
LOS 49. c: 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”.
Limitations of descriptors such as growth, defensive, and cyclical include the facts that cyclical industries often include growth firms;
even non-cyclical industries can be affected by severe recessions;
defensive industries are not always safe investments;
business cycle timing differs across countries and regions; and
the classification of firms is somewhat arbitrary.
LOS 49. d: Explain how a company’s industry classification can be used to identify a potential “peer group” for equity valuation.
A peer group should consist of companies with similar:
- business activities
- demand drivers
- cost structure drivers, and;
- availability of capital
To form a peer group, the analyst will often start by identifying companies in the same industry, but the analyst should use other information to verify that the firms in an industry are comparable.
LOS 49. e: Describe the elements that need to be covered in a thorough industry analysis.
A thorough industry analysis should:
- Evaluate the relationships between macroeconomic variables and industrial trends.
- Estimate industry variables using different approaches and scenarios.
- Check estimates against those from other analysts.
- Compare the valuation for different industries.
- Compare the valuation for industries across time an determine risk and rotation strategies.
- Analyze industry prospects based on strategic groups.
- Classify industries by their life-cycle stage.
- Position the industry on the experience curve.
- Consider demographic, macroeconomic, governmental, social, and technological influences.
- Examine the forces that determine industry competition.
LOS 49. f: Describe the principles of strategic analysis of an industry.
Strategic analysis of an industry involves analyzing the competitive forces that determine the possibility of economic profits.
Porter’s five forces that determine industry competition are:
- Revelry among existing competitors
- Threat of entry
- Threat of substitutes
- Power of buyers
- Power of suppliers
LOS 49. g: Explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price competition.
High barriers to entry prevent new competitors form taking away market share, but they do not guarantee pricing power or high return on capital, especially if the products are undifferentiated or barriers to exit result in overcapacity. Barriers to entry may change over time.
LOS 49. g: Explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price competition.
While market fragmentation usually results in strong competition and low return on capital, high industry concentration may not guarantee pricing power. If industry products are undifferentiated, consumers will switch to the cheapest producer. Overcapacity may result in price wars.
LOS 49. g: Explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price competition.
Capacity is fixed in the short run and variable in the long run. Undercapacity typically results in pricing power. Producers may overinvest in new capacity, especially in cyclical industries or in the capacity is physical and specialized. Non-physical capacity comes into production and can be reallocated more quickly than physical capital.
LOS 49. h: 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. List them.
Phases of the industry life-cycle model are the embryonic, growth, shakeout, maturity, and decline stages.
