7. Company Analysis
7.1. Industry Analysis
A company’s fortunes, to a large degree, are tied to overall conditions in the industry in which it finds itself. An individual company’s performance may be better or worse than the industry as a whole. In addition, all of a company’s products or services may straddle different industries as in the case of a conglomerate. However, understanding the industry or multiple industries that a company competes in helps to set a baseline for understanding what external conditions a company is facing at the present and in the future.
To begin with, we introduce the five forces analysis, a framework introduced by Michael Porter in the late 1970’s. The five forces analysis simplifies an industry’s environment into five forces which affect the competitive environment in the industry and an individual company’s profitability. The five basic forces are:
• Bargaining Power of Customers. This refers to the multiple factors which affect the customers’ ability to affect the profitability of a given industry. A very important factor is the concentration of customers compared to the concentration of firms in a given industry. Generally, the more customers compared to firms, the lower the customers’ bargaining power, and vice versa. The ease with which customers can switch products and the ability of buying firms to vertically integrate into their suppliers’ industry are other factors. The price sensitivity of the customers is another factor. For instance, if the product constitutes a low percentage of the total costs of the customer but the product is important to the customer, the customer may be less price sensitive. The volume which buyers command is another factor.
• Bargaining Power of Suppliers. Factors which can affect the bargaining power of suppliers include: 1) the concentration of suppliers to an industry compared to the concentration of firms in that industry, 2) the ease of switching away from the industry, 3) the availability of substitute products, 4) the price sensitivity of firms in the industry to input prices, and 5) the ability of suppliers to integrate downwards.
• Threat of New Entrants. Potential barriers to entry in an industry by newcomers include: 1) high capital requirements, 2) a steep learning curve, 3) high brand equity for existing players, 4) government regulation (discussed in more detail below), 5) switching costs, and 6) access to resources.
• Threat of Substitute Products. This depends on the following factors: 1) buyer switching costs, 2) the similarity of the substitute product to the reference product and 3) the price performance of the substitute product as compared to the reference product.
• Intensity of Competitive Rivalry. The intensity of competition within an industry depends on the following: 1) the number and relative size of competitors, 2) the industry growth rate, 3) industry exit barriers, 4) whether the industry has high fixed costs or not, and 5) if there is little differentiation between products either in performance or in brand loyalty.
We have used Porter’s five forces model as a starting off point above. However, in some cases, the model is not complete. In addition to the forces above, the following factors may also be considered:
• Impact of Government. The impact that government regulations can have in an industry varies. One area in all industries in which the government takes a large interest is antitrust. Antitrust law is meant to prevent the development of monopolies which would allow a single company or small group of companies to earn unreasonably high profits. Antitrust law has created uncertainty for Microsoft in recent years as various governments around the world have investigated the company for uncompetitive practices. The deregulation of the telecommunications industry in 1996 had a great impact on the telecommunications industry. Some industries are highly regulated to protect consumers. The banking industry must follow many government regulations, such as reserve requirements, which have been set-up to prevent banks from taking too much risk. These regulations may change from time to time, affecting an industry’s prospects. Government de-regulation of the airline industry in the late 1970’s had a great impact on airline companies.
• Company’s Relationship to its Community. A company’s relationship to its local community may also be a key factor. In the auto industry, the local community in which domestic factories are situated often consists primarily of auto industry employees. The relationship of U.S. auto companies to the United Auto Workers, the trade union for workers in the auto industry, is a key factor that would need to be considered when analyzing the U.S. auto industry. The terms of new union contracts can affect the profitability of auto companies for many years. In fact, previous union contracts which granted large health and pension benefits to auto workers are a key factor in the difficulties the U.S. auto companies are facing today. Another area where local communities are important in holding companies accountable for degradation of the environment. For instance, logging companies may face difficulty in extracting profits in local communities where there is a strong desire to protect forests. Biotechnology companies or genetically modified food producers may face local communities who wish to restrict their activities on moral grounds.
• Strategic Alliances. The five forces model’s framework assumes that the primary structure of an industry is a competitive structure. In some cases, however, an industry may consist of certain strategic alliances in which competitors or suppliers and customers work together to achieve common ends. The alliance may make an industry healthier than it otherwise would be or it may be especially beneficial to certain members of the alliance. The relationship among governments and companies in different parts of the oil industry may be characterized by strategic alliances. In some cases, a key factor may be the relationship between a country and an oil company rather than an analysis of the bargaining power of the buyers or the suppliers. The relationship between computer manufacturers and Intel and Microsoft may also be characterized as a strategic alliance to some degree.
In addition to qualitative industry analysis, spending time working out some quantitative assumptions is also helpful. The five forces analysis is particularly useful for making judgments about an industry’s profitability. The three major quantitative assumptions we would suggest you spend some time on are:
• Industry Size. An estimate of an industry’s total size is useful. Knowing a given company’s size and the size of the total industry, you can calculate a market share for the company. This may help in estimating how dominant the company is within its industry and how much growth potential there is for a company within its industry.
• Industry Growth Rate. An industry’s growth rate should have a direct impact on a company’s growth rate. Generally, higher growing industries will show higher industry profitability. A high growth rate, if it is profitable growth, may allow a company to increase its value at a more rapid rate.
• Industry Profitability. Average profit margins in an industry can be used as a guide to the likely profitability of a given company. A highly competitive industry is likely to see lower profit margins while a less competitive one will see higher margins. It is also useful to understand why a company may differ from the industry average in profitability. If brands command a high loyalty, products with strong brands may command a higher profit margin.
Quantitative industry assumptions such as those above will be especially useful for building earnings forecasts for a given company, which we cover in a later section.
7.2. Company Analysis
The previous section described some methods of gauging the overall conditions in an industry. In this section, we will go over some methods of looking at the prospects of a specific company. Here are three of the most important things to determine when analyzing a company:
• Company’s Competitive Position: How Wide is the Moat? A good company should have a sustainable competitive position against its competitors. In other words, it should be difficult and take a long time for a competitor to erode a good company’s market share and/or profitability. This can be achieved in many ways. Brand equity is one of the more common ways. For instance, Coca-Cola’s position in the soda market would take quite a lot of resources to attack. This is one reason why Warren Buffett made a big investment in Coca-Cola shares when he thought the share price was attractive. To some extent, E-Bay’s position as the key auction house on the internet would be difficult to attack as the more users that use E-Bay’s selling system, the more useful the system becomes. As E-Bay gets larger, it’s position becomes more and more secure. While the future in the technology industry is more difficult to project, it could be said that at the present time, Microsoft has a key position in the personal computer operating system market. Technology is more difficult than some other consumer products because, in the future, the products produced may become obsolete and not needed. For instance, if everyone moves to use web-based applications in the future, the primacy and usefulness of the personal computer operating system will be greatly eroded. In contrast, chewing gum or soda pop is unlikely to become obsolete in the very near future.
• Company’s Competitive Position: Improving or Getting Worse. After trying to gauge the sustainability of a company’s competitive position, it is also useful to gauge whether the company’s competitive position is likely to improve or to get worse. If it is likely to improve, and this is not widely acknowledged as evidenced by an undervalued share price, then perhaps a good investment opportunity is in sight. A company may have invested in proprietary methods to lower its costs which are not available to competitors. It may have introduced new products that are allowing it to gain market share. It may have introduced a successful marketing campaign that is improving its brand equity permanently.
• Management Analysis. Probably the most important trait to look for when analyzing a company’s management is integrity. You should be put off a company by any signs that the management is dishonest or unethical. Avoiding scandals at companies can save you from a lot of losses. An ethical management should be a non-negotiable item with regards to the types of companies you invest in.
Peter Lynch, the famed Fidelity Investments fund manager, is famous for saying “Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.” This brings us to the next point – after integrity, having an effective management system and process in place is of primary importance. A charismatic manager may dazzle the press and provide short-term motivation to employees. However, if a company becomes too dependent on one charismatic manager, it leaves itself vulnerable if the manager leaves. Therefore, sometimes the sign that a company will be managed well is actually in the well developed and effective processes and culture of a company, rather than in any specific manager.
An additional positive of a strong management process is that companies with reputations for developing strong management processes in-house also tend to have deep benches. Toyota and GE are companies which have successfully developed effective management systems and processes. Since industry conditions are constantly changing, you want to find a management who’s judgment you would trust to make the right decisions, while not knowing exactly what sorts of decisions might need to be made in the future since the future is not entirely predictable. Companies with deep benches and good processes are more likely to be able to roll with the punches.
Finally, here is a quote from Warren Buffett: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” This highlights the fact that some factors are out of management control. If an industry is in decline, a good management may not be able to overcome poor industry conditions, and, in this case, it may be better to find another industry to invest in.
Taking into account the overall industry which a company finds itself in, and the company’s competitive position and characteristics, you can take company analysis a step further and attempt to develop some quantitative estimates of future company performance. It may be helpful to return to this section after reviewing the next section as we discuss full company financial statements in detail in the next section. Two important parameters are:
• Company Revenue Growth Rate. A good starting point for the company’s overall revenue growth rate is the industry growth rate, which we had described above. Using this as a base, you can judge whether the specific company you are analyzing should be growing faster, slower or in-line with its industry. If the company has introduced a successful new product, for instance, and is gaining market share, it would probably grow faster than the industry as a whole. In contrast, if the company’s products have not kept up with the competition, perhaps the company may find it necessary to discount its products to sell them. In this case, revenue growth may be lower than the industry due to weaker pricing power, even if the company is able to maintain its market share.
• Company Profitability. A good starting point for company profitability is the previous year’s profitability. From there, you should look for reasons why profitability in the future should be higher or lower than it has been in the past. It is especially important to adjust the company’s historical profitability for any one-time special items that are unlikely to recur in the future. If the company has introduced new higher margin products and these are growing at a faster rate than the company average, the company’s profitability may rise. Or, if the company is a manufacturing company and the cost of inputs is rising, perhaps company margins may begin to fall. A good cross-check would be to take a look at industry profitability, on average, or if this is unavailable, make some comparisons to similar companies. If there is a big difference in profitability between similar companies and the company being analyzed, it would be useful to understand why those differences occur and whether or not they are justified. If they are not justified, it is possible that the company’s profitability may start to converge to the industry’s average level.
The Financial Engineer 