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INDUSTRY ANALYSIS
 Chapter One

Learning Objectives
a. Explain uses of industry analysis and the relation of
industry analysis to company analysis;
b. Compare methods by which companies can be
grouped, current industry classification systems, and
classify a company;
c. Explain the factors that affect the sensitivity of a
company to the business cycle;
d. Explain the uses and limitations of industry and company
descriptors such as “growth,” “defensive,” and “cyclical.”
e. Explain how a company’s industry classification can be
used to identify a potential “peer group” for equity
valuation;
f. Describe the principles of strategic analysis of an industry;
g. Describe industry life cycle models and classify an industry
as to life cycle stage;
h. Describe macroeconomic, technological, demographic,
governmental, and social influences on industry growth,
profitability, and risk.
 INDUSTRY ANALYSIS &
CLASSIFICATION 1
SENSITIVITY TO BUSINESS
CYCLE 2
Chapter PEER GROUP 3
Two 2 PORTER’S FIVE FORCES
MODEL 4
INDUSTRY ANALYSIS INDUSTRY LIFE CYCLE
MODEL 5
EXTERNAL FACTORS 6
CHAPTER TWO: INDUSTRY ANALYSIS
2.1: INDUSTRY ANALYSIS & CLASSIFICATION
2.1.1: Industry Analysis & Company Analysis
q Industry analysis provides a framework for understanding the environment where the firm operates. Analysts
focus on a group of specific industries so that they can better understand the business conditions the firms in
those industries face.
q Understanding a firm’s business environment can provide insight about the firm’s potential growth,
competition, and risks. For a credit analyst, industry conditions can provide important information about
whether a firm will be able to meet its obligations in the future or not.
q In an active management strategy, industry analysis can identify industries that are undervalued or
overvalued in order to weight them appropriately. Some investors engage in industry rotation, which is
overweighting or underweighting industries based on the current phase of the business cycle.

2.1.2: Industry Classification Systems

q One way to group companies into an industry is by the products and services they offer. For example, the
firms that produce automobiles constitute the auto industry.
q A sector is a group of similar industries. Hospitals, doctors, pharmaceutical firms, and other industries are
included in the health care sector.
q Systems that are grouped by products and services usually use a firm’s principal business activity (the largest
source of sales or earnings) to classify firms.
q Examples of these systems include the Global Industry Classification Standard (GICS), Russell Global Sectors
(RGS), and Industry Classification Benchmark.
q Firms can also be classified by their sensitivity to business cycles. This system has two main classifications:
cyclical and non-cyclical firms. 4
CHAPTER TWO: INDUSTRY ANALYSIS
2.1: INDUSTRY ANALYSIS & CLASSIFICATION
2.1.2: Industry Classification Systems
q Statistical methods, such as cluster analysis, can also be used. This method groups firms that historically have
had highly correlated returns. The groups (i.e., industries) formed will then have lower returns correlations
between groups.
q This method has several limitations:
q Historical correlations may not be the same as future correlations.
q The groupings of firms may differ over time and across countries.
q The method is susceptible to statistical error.

2.1.3: Commercial Classification

q Several index providers classify firms. Some use three levels of classification, while others use four levels. The
providers generally use firm fundamentals such as revenue to classify firms. Although the nomenclature differs
among providers, the broadest category is generally the sector level, followed by industry and sub-industry.
q Commercial industry classifications include the Global Industry Classification Standard developed by
Standard & Poor’s and MSCI Barra, Russell Global Sectors, and the Industry Classification Benchmark
developed by Dow Jones and FTSE.
q Sectors and firm compositions representative of those used by commercial providers are as follows.
q Basic materials and processing firms produce:
Building materials Chemicals
Paper and forest products Containers and packaging
Metals, minerals, and mining 5
CHAPTER TWO: INDUSTRY ANALYSIS
2.1: INDUSTRY ANALYSIS & CLASSIFICATION
2.1.3: Commercial Classification
q Consumer discretionary firms are cyclical and sell goods and services in industries such as:
Automotive Apparel
Hotels and restaurants
q Consumer staples firms are less cyclical and sell goods and services in industries such as:
Food Beverage
Tobacco Personal care products
q Energy firms are involved in:
Energy exploration Refining
Production Energy equipment
Energy services
q Financial services firms include firms involved in:
Banking Insurance
Real estate financing Asset management
Brokerage
q Health care includes:
Pharmaceuticals Biotech
Medical devices Health care equipment
Medical supplies Health care services
6
CHAPTER TWO: INDUSTRY ANALYSIS
2.1: INDUSTRY ANALYSIS & CLASSIFICATION
2.1.3: Commercial Classification
q Industrial and producer durables firms produce capital goods for commercial services industries
including:
Heavy machinery and equipment Aerospace
Defense Transportation
Commercial services and supplies
q Real estate firms are involved in the development, management, and operation of real properties,
including:
Real estate investment trusts (REITs) Real estate services firms
q Technology firms sell or produce:
Computers Software
Semiconductors Communications equipment
Internet services Electronic entertainment.
Consulting and services.
q Telecommunications firms include wired and wireless service providers. Utilities includes electric, gas, and
water utilities. Some industry classification providers include telecommunication and utilities in the same
group, while others separate them.

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CHAPTER TWO: INDUSTRY ANALYSIS
2.1: INDUSTRY ANALYSIS & CLASSIFICATION
2.1.4: Government Classification
q Several government bodies also provide industry classification of firms. They frequently do so to organize the
economic data they publish. A main thrust of their systems is to make comparisons of industries consistent
across time and country. The main systems are similar to each other.
q The methodologies that government providers use in their compilation of industry groups differ from those
used by commercial providers. Most governments do not identify individual firms in a group, so an analyst
cannot know the groups’ exact composition. Commercial providers identify the constituent firms.
q Government systems are updated less frequently. Governments do not distinguish between small and large
firms, for-profit and not-for-profit organizations, or private and public firms. Commercial providers only include
for-profit and public firms and can delineate by the size of the firm.

8
CHAPTER TWO: INDUSTRY ANALYSIS
2.2: SENSITIVITY TO BUSINESS CYCLE
2.2.1: Cyclical Firms
q A cyclical firm is one whose earnings are highly dependent on the stage of the business cycle. These firms
have high earnings volatility and high operating leverage. Their products are often expensive, non-
necessities whose purchase can be delayed until the economy improves.
q Examples: basic materials and processing, consumer discretionary, energy, financial services, industrial and
producer durables, and technology.

2.2.1: Non-Cyclical Firms

q A non-cyclical firm produces goods and services for which demand is relatively stable over the business
cycle.
q Examples: health care, utilities, telecommunications, and consumer staples.
q Non-cyclical industries can be further separated into defensive (stable) or growth industries.
q Defensive industries: are those that are least affected by the stage of the business cycle and include
utilities, consumer staples (such as food producers), and basic services (such as drug stores).
q Growth industries: have demand so strong they are largely unaffected by the stage of the business
cycle.

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CHAPTER TWO: INDUSTRY ANALYSIS
2.3: PEER GROUP
q A peer group is a set of similar companies an analyst will use for valuation comparisons. More specifically, a
peer group will consist of companies with similar business activities, demand drivers, cost structure drivers,
and availability of capital.
q To form a peer group, an analyst will often start by identifying companies in the same industry classification,
using the commercial classification providers. Usually, the analyst will use other information to verify that the
firms in an industry are indeed peers. An analyst might include a company in more than one peer group.
q The following are steps an analyst would use to form a peer group:
q Use commercial classification providers to determine which firms are in the same industry.
q Examine firms’ annual reports to see if they identify key competitors.
q Examine competitors’ annual reports to see if other competitors are named.
q Use industry trade publications to identify competitors.
q Confirm that comparable firms have similar sources of sales and earnings, have similar sources of
demand, and are in similar geographic markets.

10
CHAPTER TWO: INDUSTRY ANALYSIS
2.4: PORTER’S FIVE FORCES MODEL
q One component of an analyst’s industry analysis should be strategic analysis, which examines how an
industry’s competitive environment influences a firm’s strategy. The analysis framework developed by
Michael Porter delineates five forces that determine industry competition.
q Rivalry among existing competitors:
q Rivalry increases when many firms of relatively equal size compete within an industry.
q Slow growth leads to competition as firms fight for market share, and high fixed costs lead to price
decreases as firms try to operate at full capacity.
q Industries with products that are undifferentiated or have barriers (are costly) to exit tend to have
high levels of competition.
q Threat of entry:
q Industries that have significant barriers to entry (e.g., large capital outlays for facilities) will find it
easier to maintain premium pricing. It is costly to enter the steel or oil production industries. Those
industries have large barriers to entry and thus less competition from newcomers.
q An analyst should identify factors that discourage new entrants, such as economies of scale.
q Threat of substitutes:
q Substitute products limit the profit potential of an industry because they limit the prices firms can
charge by increasing the elasticity of demand.
q Commodity-like products have high levels of competition and low profit margins.
q The more differentiated the products are within an industry, the less price competition there will be.

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CHAPTER TWO: INDUSTRY ANALYSIS
2.4: PORTER’S FIVE FORCES MODEL
q Power of buyers:
q Buyers’ ability to bargain for lower prices or higher quality influences industry profitability.
q Bargaining by governments and ever-larger health care providers have put downward pressure
even on patented drugs.
q Power of suppliers:
q Suppliers’ ability to raise prices or limit supply influences industry profitability.
q Suppliers are more powerful if there are just a few of them and their products are scarce. For
example, Microsoft is one of the few suppliers of operating system software and thus has pricing
power.
q The first two forces deserve further attention because almost all firms must be concerned about the threat of
new entrants and competition that would erode profits. Studying these forces also helps the analyst better
understand the subject firm’s competitors and prospects.
q Higher barriers to entry reduce competition.
q Greater concentration (few players control large part of the market) reduces competition, whereas
market fragmentation increases competition.
q Unused capacity in an industry results in intense price competition. For example, underutilized capacity
in the auto industry has resulted in very competitive pricing.
q Stability in market share reduces competition. For example, loyalty of a firm’s customers tends to stabilize
market share and profits.
q More price sensitivity in customer buying decisions results in greater competition.
q Greater maturity of an industry results in slowing growth.
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CHAPTER TWO: INDUSTRY ANALYSIS
2.5: INDUSTRY LIFE CYCLE MODEL
q Industry life cycle analysis should be a component of an analyst’s strategic analysis. An industry’s stage in the
cycle has an impact on industry competition, growth, and profits.
q An industry’s stage will change over time, so the analyst must monitor the industry on an ongoing basis.
q Embryonic stage: The industry has just started.
q Slow growth: customers are unfamiliar with the product.
q High prices: the volume necessary for economies of scale has not
been reached.
q Large investment required: to develop the product.
q High risk of failure: most embryonic firms fail.
q Growth stage: Industry growth is rapid.
q Rapid growth: new consumers discover the product.
q Limited competitive pressures: the threat of new firms coming into the market peaks during the growth
phase, but rapid growth allows firms to grow without competing on price.
q Falling prices: economies of scale are reached and distribution channels increase.
q Increasing profitability: due to economies of scale.

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CHAPTER TWO: INDUSTRY ANALYSIS
2.5: INDUSTRY LIFE CYCLE MODEL
q Shakeout stage: industry growth and profitability are slowing due to strong competition.
q Growth has slowed: demand reaches saturation level with few new customers to be found.
q Intense competition: industry growth has slowed, so firm growth must come at the expense of
competitors.
q Increasing industry overcapacity: firm investment exceeds increases in demand.
q Declining profitability: due to overcapacity.
q Increased cost cutting: firms restructure to survive and attempt to build brand loyalty.
q Increased failures: weaker firms liquidate or are acquired.
q Mature stage: There is little industry growth and firms begin to consolidate.
q Slow growth: market is saturated and demand is only for replacement.
q Consolidation: market evolves to an oligopoly.
q High barriers to entry: surviving firms have brand loyalty and low cost structures.
q Stable pricing: firms try to avoid price wars, although periodic price wars may occur during recessions.
q Superior firms gain market share: the firms with better products may grow faster than the industry
average.
q Decline stage: Industry growth is negative.
q Negative growth: due to development of substitute products, societal changes, or global competition.
q Declining prices: competition is intense and there are price wars due to overcapacity.
q Consolidation: failing firms exit or merge.

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CHAPTER TWO: INDUSTRY ANALYSIS
2.5: INDUSTRY LIFE CYCLE MODEL
q An analyst should determine whether a firm is “acting its age” or stage of industry development.
q Growth firms should be reinvesting in operations in an attempt to increase product offerings, increase
economies of scale, and build brand loyalty. They are not yet worried about cost efficiency. They should not
pay out cash flows to investors but save them for internal growth.
q On the other hand, mature firms focus on cost efficiency because demand is largely from replacement. They
find few opportunities to introduce new products. These firms should typically pay out cash to investors as
dividends or stock repurchases because cash flows are strong but internal growth is limited.
q An analyst should be concerned about firms that do not act their stage, such as a mature firm that is
investing in low-return projects for the sake of increasing firm size.

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CHAPTER TWO: INDUSTRY ANALYSIS
2.6: EXTERNAL FACTORS
q The external influences on industry growth, profitability, and risk should be a component of an analyst’s
strategic analysis. These external factors include:
q Macroeconomic factors:
q Can be cyclical or structural (longer-term) trends, most notably economic output as measured by GDP
or some other measure.
q Interest rates affect financing costs for firms and individuals, as well as financial institution profitability.
q Credit availability affects consumer and business expenditures and funding.
q Inflation affects costs, prices, interest rates, and business and consumer confidence.
q The education level of the work force. More education can increase workers’ productivity and real
wages, which in turn can increase their demand for consumer goods.
q Technology:
q Can change an industry dramatically through the introduction of new or improved products.
q Computer hardware is an example of an industry that has undergone dramatic transformation.
q Radical improvements in circuitry were assisted by transformations in other industries, including the
computer software and telecommunications industries.
q Another example of an industry that has been changed by technology is photography, which has
largely moved from film to digital media.
q Demographic factors:
q Age distribution and population size, as well as other changes in the composition of the population.
q As a large segment of the population reaches their twenties, residential construction, furniture, and
related industries see increased demand. 16
CHAPTER TWO: INDUSTRY ANALYSIS
2.6: EXTERNAL FACTORS
q Governmental factors:
q Governments have an important and widespread effect on businesses through various channels,
including taxes and regulation.
q The level of tax rates certainly affects industries, but analysts should also be aware of the differential
taxation applied to some goods.
q Governments can also empower self-regulatory organizations, such as stock exchanges that regulate
their members.
q Social influences:
q Relate to how people work, play, spend their money, and conduct their lives; these factors can have a
large impact on industries.

17