Why Use Industry Analysis When Using Financial Analysis?
Financial ratios are one excellent way to analyze your financial position. However, they mean nothing in isolation, as the performance of a company is a function of the performance of the industry. Anyone who has subscribed to Standard & Poor’s Credit Ratings prior to the GFC can attest to this.
To bring this down to a very basic example, let’s say you calculate your debt ratio at 50%. What this means is that 50% of your firm is financed with debt and 50% with equity. Is this good or bad? This is where comparative data comes in. With comparative data, then you can have some basis for comparison and can determine whether your debt ratio is appropriate for your firm. Presumably, you have previous years of balance sheet data for your business. It’s also helpful to calculate the financial ratios for several years so you can track the Trends in your ratios.
Just as important as this Trend Analysis is Industry Analysis. It’s critical, particularly in today’s economic climate, to know how your industry is performing compared to your company. For example, if your industry’s ratios are much different than your firms, you want to examine these factors and take action accordingly. Are you performing better than the Industry? Is the Industry outperforming your firm? Why? You need to do both Trend and Industry analysis for every financial ratio you calculate to get the complete picture for your firm. There are two key reasons why you need to do this:
- Take advantage of ‘tailwinds’ that will provide current and future competitive advantage.
- Mitigate Risk relating to trends and Drivers outside a Manager/ Investors control.
As another example of the importance of Industry Analysis, let’s take a stock. Regardless of the quality of the stock, it is highly unlikely to outperform if the industry is performing poorly. This is due to the simple reason that most prices are driven by large financial institutions that buy and sell the majority of the volume of stocks. Institutions generally give a very heavy weighting to the current, and expected performance of a specific industry. After market risk, this is widely regarded as the most influential factor in the performance of a stock. As no company operates in isolation, and performance of a company is a function of the performance of the Industry, analyzing the current and expected performance of the Industry (Top Down approach) is crucial.
In fact Industry analysis is also a function of Market Risk; taking into account interest rates, foreign exchange rates, and commodity prices as Key External Drivers that affect an Industry under review- and their impact upon sensitivity in supply chains. These supply chain sensitivities are what Portfolio and Risk Managers look for and can be called ‘Risk Pockets /Buckets’. Why are they important? : How would a decline of 10% in key driver like household spending, or collapse in a key supply chain sector like construction affect the overall exposure or leverage of your portfolio? In simple business terms, what impact would this have on revenue and performance?
Generally, there are two reasons why Industry Analysis is important from an investment perspective:
- The performance of a company is a function of the performance of the industry. (eg if the price of oil goes up for an industry that is reliant on oil then all the companies in the industry will be affected, as will many supply chain industries and their companies)
- Market Herd Mentality: If an industry suddenly becomes popular, or if a sudden change in the news is perceived to be good or bad for an industry, the price of the stock will be affected by the average investor’s perceptions, and most investors will follow industry trends.
Also of importance to note; a specific industry cycle is not necessarily the same as the business cycle. In many cases a specific industry may outperform or even drive in the opposite direction to the general economic cycle (counter-cyclical industries). Even within Industries, revenue volatility is a key factor to analyse as revenues can jump and crash, even though that Industry may experience overall growth of 0.1%
Painting a Clearer Picture of Financial Analysis:
There are downsides to using financial statements, too though. As a colleague of mine- Stuart Hoffman- pointed out to me, two examples can highlight those downsides:
“Consider the case of the owner of the Cleveland Indians, Dick Jacobs. In anti-trust testimony before Congress, Major League Baseball claimed the Indians’ revenue for 1998 at $125.74 million and 1997 at $113.75 million. When Jacobs took 30% of the Indians public in 1998, he had to provide a prospectus. The prospectus stated 1998 Revenue at $144.55 million and 1997 Revenue at $140.03 million. Jacobs explained, “Under generally accepted accounting principles, I can turn a $4 million profit into a $2 million loss and I can get every national accounting firm to agree with me.
The second example is Enron.”
What these examples really point to is that what goes into the model will determine what comes out of it. Data is key.
A novel way of demonstrating the importance of industry information is to compile a list of industries that have been adversely affected by technology. Financial statements don’t address how technology might affect a company. This is because Financial Analysis is backward looking.
Financial Analysis ultimately only relates how successful a company is- or has been- until today. It is Industry Analysis that will be able to relate the performance of the company to the Industry and the Industry to the economy. Taking into account the impacts of Technology, Key External Drivers, and Supply Chain factors, coupled with the current/ historical performance benchmarks will determine the likely performance of the Industry, and therefore a significant determinant of how a company or stock will perform in the future.
Industry Analysis adds a buffer to models and assumptions that pure quantitative financial models can’t account for.
Looking at the Key Success Factors that result in the success of the Major Players in an Industry will is also a strong indication of what will see a company or stock perform well in the future.
Ultimately, Industry Analysis assists decision makers with broader perspective, and a forward looking approach providing greater insight and oversight than reliance upon Financial Analysis alone.
- No company operates in isolation; the performance of a company is a function of the performance of the industry
- Industry Analysis identifies Performance Benchmarks
- Industry Analysis identifies Market & Operating Risk
- Financial Analysis has significant limitations
- Financial Analysis does not account for the impact of Technology on Industries and companies.
- Financial Analysis is backward Looking
- Industry Analysis enables you to understand what will make a company (or stock) successful in the future.
- Industry Analysis if a forward looking predictor of performance
- Industry Analysis provides a layer of judgement to Financial Analysis which gives greater predictive insight
Source: Mike McKell, Senior Business Development Manager at IBIS World (UK) Ltd., London UK