Learn how to do industry analysis using Porter’s Five Forces Model– Buying stocks isn’t hard. But choosing which ones to buy can be really tough. Industries in today’s day and age are now radically changing and evolving in the blink of an eye. One needs to consider various aspects before making an investment decision, and one such significant aspect is its Industry Analysis.
So today, we bring you a detailed guide on how to conduct an Industry Analysis and why it is a crucial part of your stock analysis process. So, let’s understand what Industry actually is.
What is Industry?
An Industry can be defined as a group of companies that are offering similar products or services.
For e.g., a Global Heavy Truck Industry includes players like Volvo, TATA Motors, Daimler AG, etc.
Similarly, Light Vehicle Industry includes Toyota, Ford, Nissan, Hyundai, etc. These companies produce light vehicles, which are close substitutes for one another.
What is Sector?
The words Sector and Industry are commonly used interchangeably, but they have slightly different meanings. A sector is a broader concept, and it generally refers to a group of related industries.
For e.g. Let’s take Health Care Sector: It comprises related industries such as Pharmaceutical, biotechnology, Hospital, medical supply industries, etc.
Introduction to how to do Industry Analysis
Industry Analysis means performing a thorough analysis of an industry’s environment, generating insights about the level of competition, the demand, and supply situation, what is the growth potential in the Industry, etc. It also takes into account both the internal and external factors that can influence any industry.
Why is Industry Analysis Important?
Before investing in any company, it’s very crucial to understand the industry in which it operates and what is the future potential of that industry. Industry analysis is a critical step in a stock valuation. It also provides us insights into the company’s growth opportunities, its competitive dynamics, and the business risks associated with the firm.
For e.g., if you are thinking of investing in a bank, take for eg. ICICI Bank. Then in order to make this decision, you need to analyze how that particular bank is performing using fundamental analysis and checking various important ratios that come with it. However, your analysis shouldn’t end here. You also need to look at how the whole banking industry has performed over the years, what are the growth drivers and what is the future potential of the industry.
How to do Industry Analysis?
There are many approaches and frameworks to do Industry Analysis. One such popular and widely used framework is Porter’s Five Forces. The key objective of the Five Forces model is to assess an industry’s attractiveness.
As identified by Porter, there are five determinants of competition in an industry. Let’s understand them here:
ALSO READ: Fundamental Analysis for Beginners!
The threat of New Entrants
This aspect assesses how difficult it would be for new competitors to enter the Industry. Industries in which companies can easily enter and start their operations will generally be more competitive than industries with high barriers to entry. A company can sustain its economic profits for longer periods if it operates in an industry with high barriers to entry.
An example of an Industry with Low Barriers to entry: Restaurants
Anyone with a modest amount of capital can open a restaurant. Popular restaurants quickly attract competition. Since this industry is very competitive, therefore many restaurants fail in their first few years of operations.
An example of an Industry with High Barriers to entry: Retail Grocery Chains
Retail Grocery Chains like D-Mart and Reliance Smart Retail have their chains all over India, and barriers to entry in this kind of industry are extremely high due to the massive capital costs required in this business.
So, in a nutshell, if a company operates in an industry that has high barriers to entry, then the company has a strategic advantage.
Bargaining Power of Suppliers
The power of suppliers means how easily suppliers can influence the prices of their supplies. It is affected by a number of factors such as how many suppliers there are, what is the switching cost for the company to different suppliers etc. If there are few suppliers in the industry or if it involves too much switching cost, then the bargaining power of suppliers will be higher. This is why suppliers of scarce or unique elements often possess significant pricing power.
On the other hand, if there are plenty of suppliers in the market or switching cost is low, then suppliers will have less bargaining power, and they won’t be able to impact and drive up the input costs easily.
Bargaining Power of Buyers
Here we examine how much power buyers exert, which allows them to dictate the price, quality, or supply of the products. Some of the factors which affect Buyers’ Power are the total number of customers, how significant each customer is, switching costs for the buyer, availability of substitute or similar products, etc.
When only a few powerful buyers are present in the market, then they may easily exert their buying power over the company. But if there exists a large number of independent buyers, then they may not be able to dictate the terms.
Threat of Substitutes
Substitute goods mean the availability of similar products or services offered by some other company. If the company sells a product that is entirely unique and has no close substitutes, it will have more power in dictating price and supply.
But if some product has close substitutes which are easily available, then the customer can switch to some different brand or company whenever he/she feels the need. It can negatively affect the demand if customers choose other ways to satisfy it. Thus, the presence of close substitutes weakens the power of the company.
Rivalry among Existing Competitors
It refers to the number of rivals or competitors present in a particular industry as well as their capacity to undercut other companies. If the Rivalry among existing companies is high, which means if there is cut-throat competition between companies offering alike or similar products or services, then the company has less power over the prices and other factors.
On the other hand, if the competitive rivalry is low, then the company is able to exert greater power over the prices and other terms of the deal to achieve higher profitability and sales.
We can use the Porter Five Forces model to analyze and assess different industries to see which ones are attractive, which ones have growth potential, what the competitive dynamics are, and so on.
Other than this, it is also essential to analyze various external factors which are affecting the industry’s growth, such as macroeconomic, technological, demographic, governmental, and social influences, etc.
External Factors that Impact Industries
Now let’s see what are the external factors that impact industries –
- Macroeconomic Influences: This encompasses trends in overall economic activity that affects demands for certain industry products/ services. For e.g., GDP growth, Changes in Interest rates, availability of credit, etc.
- Technological Influences: New technologies create new and improved products that can radically change an industry. For e.g., the use of Artificial Intelligence (AI) & Machine Learning (ML), Blockchain technology, etc., is transforming the whole business landscape.
- Demographic Influences: Factors like change in population size, the distribution of age, and other demographic characteristics also have significant effects on the types of goods/services consumed.
- Government Influences: Government exerts influence on Industries through their rules and regulations of policies, taxes, subsidies, initiatives, etc.
- Social Influence: Social factors such as how people work, spend their money, and conduct other aspects of their lives can also significantly affect sales of various industries.
In Closing
This was a comprehensive guide on how to do industry analysis. These factors will help you gain a deep understanding of the industry and generate valuable insights which will help you make a better investment decision.
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