Aside from the company’s financial disclosures, the analyst must also perform an analysis of the economy and the industry in which the company operates.
With respect to information on the economy, the analyst must evaluate how the company performs in different economic environments. Armed with this information and economic forecasts, the analyst will be able to develop better forecasts of how the particular company will perform in the future.
Economic data that is needed includes:
- Production and income;
- Investment activity;
- Interest rates;
- Stock prices;
The analyst must also take a close look at the industry or industries in which the company operates. The important aspects of the industry analysis are:
- Nature of competition;
- Market share for each company in the industry;
- Labour conditions;
- Regulatory conditions;
- Price elasticity of demand and supply;
- Sensitivity of demand to economic conditions.
In the analysis of an industry and a company, it is important to understand the sources of value added. In basic economics, we have learned that a firm creates value when it has a comparative or competitive advantage. When analyzing an industry and a company, the financial analyst must identify the comparative or competitive advantage that provides economic profit and sustainable growth in the future. The economic profit (i.e. the economic value added) is the income of the company in excess of the frm’s cost of capital. A company’s sustainable growth is the growth rate that it can keep up without having to resort to additional financial leverage.
One way to analyze these advantages is to use the five factors that are outlined by Michael Porter :-
(a) Threat of new entrants – the industry/company may have an advantage if there are barriers to new entrants.
(b) Bargaining power of buyers – the stronger the bargaining power of buyers, the less advantage that a/an industry/company has.
(c) Bargaining powers of suppliers – the greater the bargaining power of suppliers, the lower the economic profit.
(d) Rivalry among competitors – the more competitive the industry, the lower the economic profits for any member of the industry
e) Threat of substitutes – the greater the ability of competitors to imitate the products or services of a company, the lower the potential economic profit. Patents, trademarks and copyrights will lower the threat of substitutes.
These are often referred to as Porter’s Five Forces. As the analyst examines the industry and the company – past, present and future – these questions must be addressed:
(i) What are the sources of the industry’s and company’s economic profit?
(ii) What are the sources of the company’s sustainable growth?
The analysis of a company requires looking closely at the company’s financial history and recent events, with a goal of assembling the future prospects of the company. The types of information that an analyst must gather include:
(a) Financial statement data and related disclosures;
(b) Major news items in recent years;
(c) Position and market share in the industry;
(e) Where the company is in its life cycle (i.e. high growth/ development, maturing, declining);
f) Contributions of major product, divisions or subsidiaries to the company’s performance;
(g) Research and development efforts;
(h) Sensitivity of company to commodity prices (e.g. oil);
(i) Major litigation.