How to do industry analysis?
Do you conduct research before investing in any company? Do you look into the macro picture before investing?
Let me tell you that before investing in a company it’s very important to conduct industry analysis as it will give you the broader picture of the overall industry.
Industry analysis is an important assessment tool which gives you an idea about the complexity involved in a particular industry. The parameters like political and economic scenarios are studied in detail which affects the development of an industry. Political parameters help in identifying the taxation structure and the government regulation while the economic scenario helps in understanding the business cycle of an industry.
A very useful and a simple approach to start with industry analysis would be by answering a set of questions which include-
- Is it a good industry to invest for long term?
- What are the growth drivers and the challenges faced by the industry?
- Who are the main players in the industry and why are they so dominant?
- What are the factors which will drive the industry in the future?
Porter five force model
The business strategist often use Porter’s Five Forces model to conduct industry analysis. Porter is a very renowned Harvard professor, famous for his work in developing industry analysis model.
“A strategy delineates a territory in which a company seeks to be unique”
The main purpose of this model is to identify the attractiveness of an industry. Moreover, this model also helps in identifying the competitive scenario in which the company operates and also a good starting point for strategy formulation.
Porter was of the view that the combined force of these five factors shapes the potential of the industry. Let’s discuss them in little detail-
1) Bargaining power of suppliers
It is one of the very important factors and it becomes very relevant especially when there are limited sellers. In such a scenario they may impose huge pressure on the businesses by reducing product quality and availability and by increasing prices. A strong seller basically reduces the profit element for the buyer and makes the industry more competitive.
The factors which contributes to supplier power are as follows-
- In case of high switching cost
- When there are no substitutes available
- Limited suppliers
- Product is a necessity item
Have a look on NSE Academy Certified Equity Research Analysis for better understanding.
2) Bargaining power of buyers
The bargaining strength of the buyer can exert a huge pressure on the businesses in terms of attaining the product at cheaper price, quality product or improved customer service. The impact will be more if the buyers are concentrated.
The buyers increase the level of competition of competition within the industry to bargain for decrease in price and improved service.
The following are the factors which you need to focus in order to assess the power of buyer-
- Transaction volume
- Analyse the switching cost
- Concentration of buyer
- Customer’s sensitivity
3) Rivalry among existing firms
The level of competition in the industry would decide the amount of pressure which one firm has on another. The firm will try to eat away the market share and the profit of another firm in case of intense competition and restricts the profitability of each other.
This is the reason the firms in the highly competitive industry end up earning low return due to high competition cost. Warren Buffett likes to invest in industries with moats. In simple words, this allows the firm to have a strong position so that competitors cannot penetrate easily.
4) Threat of new entrants
In case of low entry barrier, there would be a change of new entrants into the market thus posing a threat to the existing competitors in the industry and vice versa.
The profitability and the market share of the existing competitor would decrease with the increase in the level of competition in the industry. The following are the factors which would impact the above threat-
- High fixed cost
- Restriction by the government
- Existing loyalty to the brand
- Higher switching cost
5) Threat of substitutes
This is one of the most crucial factor in the industry and may affect the competitive environment of the firm in the industry, thus influencing firm’s profitability. The availability or non-availability of the substitutes affects industry’s profitability and plays a very important role.
A substitute product is one which basically offers similar benefit to the consumer as the product in question. Say if the price of tea goes up drastically, a tea drinker may switch to its substitute say coffee.
Now, let’s analyse the above five points using a practical example-
Say you want to open a restaurant and thus wants to conduct an analysis on the same. So you easily do so with the help Porter’s five force model.
- Low cost of substituting
- Large number of suppliers
- No real supplier power
- High ability to substitute
- Large number of buyers
- Low price sensitivity
- Low cost of substituting
Threat from competition
- Low switching cost
- Large number of competitors
- Low customer loyalty
Threat of new entry
- No real barriers to entry
- Economies of scale for large manufacturers
- Entering in the industry is expensive
- Trained manpower is easily available or can be trained
Threat from Substitution
- Large number of substitutes
- Low cost of substitution
Simply by identifying the strength and direction of each force, you can analyse company’s strength within the industry and its ability to generate sustained profit in the future. In simple words, Porter’s 5 force will help you analyse profit potential and other important parameters in the industry.
About the Author:
This article is written by Mr Ankit Jaiswal – Knowledge Associate – Elearnmarkets. He is a commerce graduate from St. Xavier’s college, Kolkata. He strongly believes in the following saying by Warren Buffett-“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it”