An important part of the framework used by research analysts to evaluate a company is the structure of the economic and industry analysis. Why does an analysis of the economy and the industry matter? It is because these two aspects provide the framework or environment in which the company operates. A great company with good model and a sound management will still find it hard to profitably operate if the economic and industry structure is unfavourable.
Economic Structure: Macroeconomic and Microeconomic Analysis
When we talk about macroeconomics, the reference is to the economy as a whole. Microeconomics refers to individuals, households and business units. Both are equally significant. Macroeconomics drives the monetary and fiscal policy and these have an important bearing on the performance of companies. Microeconomics refers to the demand generation and spending power of households and refers to the demand aspect for products and services.
Macro factors impacting company valuations
- GDP growth on a quarterly and annual basis
- Inflation rate at CPI and WPI level
- Index of Industrial Production
- Core sector growth
- Interest rates in the economy
- Imports, exports and trade deficit
- Fiscal deficit and current account deficit
- Exchange rate movements
- Monetary policy drivers – repo rates, liquidity, CRR, SLR etc
- Fiscal policy drivers – direct taxes, indirect taxes, government spending etc
Micro factors impacting company valuations
- Personal income levels on per capital basis
- Household demand and retail inflation
- Propensity to consume among households
- Propensity to save among households
- Investment patterns – gold, equity, mutual funds etc
- Cost of living and household budgets
Sources of Information for Macroeconomic Analysis
For detailed statistics on macro and micro analysis, the following sources can be useful.
- Website of the Ministry of Finance
- Website of the Ministry of Commerce
- Budget documents available on indiabudget.nic.in
- Economic Survey available on indiabudget.nic.in
- Economic research papers published by reputed universities
- RBI data bank and RBI circulars
- Global websites like sec.gov.us for global macros
- Reputed data sources like Bloomberg, Reuters etc
- World Gold Council
- Website of the International Monetary Fund
- Website of the World Bank / Asian Development Bank
- Independent data providers like CMIE
Industry Analysis – Why It Matters?
Industry analysis is normally the second step after you are through with a detailed study of the macroeconomic and microeconomic environment. There are a number of factors that go into industry analysis like the life cycle of the industry, level of maturity, profitability of the industry, prospects for consolidation etc. The next step is to evaluate some of the unique features of the industry and why the industry structure could make the investment in the stock attractive. Here are 3 important industry analysis models.
- Michael Porter’s 5-factor industry analysis
- PESTLE Analysis model
- BCG Matrix model
I - Michael Porter’s 5-Factor Industry Model
Porter’s analysis of an industry is best captured by the above chart. There are 5 forces that impact the attractiveness of an industry and they can be further divided into 2 vertical and 3 horizontal factors.
Vertical Factors - Industry Rivalry
An industry where rivalry among the existing players is high will see tough competition and pressure on pricing. In India, aviation and telecom are examples where existing rivalry is extremely tough and impacts the pricing power of the participants. That is an important input going into company valuations. Normally, this factor of the Porter model can be negative for the companies operating in the industry because of the following reasons:
- Numerous companies operate in the business segment
- Product / service differential is limited and hence unique positioning is not possible
- Price leadership tends to be the obvious strategy for players in the industry
- Switching cost for customers from competition is fairly low as is the effort
The normal rule is that lesser the intensity of the rivalry and competition within the industry or product / service group, it is positive for the company.
Vertical Factors - Threat of Substitutes and risk of new entrants
For simplicity, we are combining two factors into one. Industries go through significant changes and are in a constant flux. Substitutes come from different source and in different forms. Online ecommerce offered a substitute for organized retail players. Electric cars are offering a substitute for auto players. Cement pipes industry lost relevance to steel and plastic pipes, which were cheaper, more flexible and also cost effective. Something like the camera faced substitution threat from improved mobile phones with superior cameras. The list can go on. Normally the threat of substitutes is high if:
- Substitutes offer equal or better experience to customers
- Substitutes are available easily at a lower cost and are more efficient
- Switching cost for customers is very low
Normally, lower the threat of substitutes the better it is for the prospects of the company being analyzed.
Horizontal Factors - Bargaining Power of Buyers
Buyers can exert pressure and dictate prices if there are many sellers with similar product offerings. The reverse is true if the number of sellers is low and hence the buyers do not have much of a bargaining power. It is the function of number of buyers and sellers and differentiation in their products/services, which determines the bargaining power of buyers in an industry. Bargaining power of buyers will be high if:
- Competitive intensity in the industry is strong
- Products/Services are standardized with little or no differentiation
- There are close substitutes available and the switching cost is low
- Buyers are large and organized or if it is the government
Horizontal Factors - Bargaining Power of Suppliers
Customers rarely bargain over the fees charged by hospitals or schools? But the same Consumers do bargain for provisions and white goods. Why is that? It has to do with the bargaining power of the supplier. As a patient or a student, your bargaining power is fairly limited. On the other hand, markets are competitive and you have the upper hand. This is just looking at the bargaining power of buyers from a different perspective.
Suppliers’ bargaining power will be high if:
- Number of suppliers are limited and buyers are many
- Supply is of some critical or high value input
- Competitive intensity is low and products can be differentiated.
- If there are veritable substitutes for the product / service
- Switching cost for the customers is high
II - Pestle Analysis Model
PESTLE Analysis is actually an abbreviation and stands for Political, Economic, Socio-cultural, Technological, Legal and Environmental Analysis. This is a 360 degree analysis and is done more from the perspective of a business which is looking to set up operations and is evaluating alternate locations. For example, if an American company is looking to outsource its electronic manufacturing to Asia, it has options like India, China, Vietnam, Bangladesh, Thailand and The Philippines. The question is on what basis this evaluation can be done? The answers are provided by PESTLE analysis and this model analyses the following factors that will influence the decision of the business.
- Political analysis looks at the political structures. Typically businesses prefer established democracies with rule of law. Also they prefer a capitalist economic structure than a communist structure as the former is more business friendly.
- Economic parameters include GDP growth, inflation, interest rates, composition of imports and exports, balance of payment and exchange rate stability. Businesses are keen to ensure that the monetary policy is not too tight or the fiscal policy is not too profligate
- Social and cultural aspects include demographic profile, sex ratio, education and skill levels, health and social values, honouring of contracts, propensity to buy and the propensity to save etc.
- Technology plays a crucial role in taking businesses to the next level. Scientific temper among students, investment in R&D, willingness to adapt all matter.
- Legal architecture, soundness of legal system, maintenance of law and order and consistency of enforcement of courts are all important aspects.
- Environment friendliness, greenhouse emissions, pollution control, policy on waste disposal and protection of environment are key factors.
It is based on a combination of these factors that the decision is taken.
Boston Consulting Group (BCG) Matrix
While Porter’s model and PESTLE are more macro in nature, BCG is more specific to a company and even more granular break-down of the product / service categories. The BCG matrix can be best captured by the chart below:
According to the BCG matrix, business segments / products can be classified as:
- Stars: Products or segments in a business where market is growing rapidly and company is having substantial market share. They are the growth areas.
- Cash Cows: These segments require low cash infusion for investment to maintain sustain shares but steadily generate cash for the company. These businesses can fuel growth in other high growth businesses like stars.
- Dogs: They have slow growth rates and the business is intensively competitive. Cash generation is low and growth prospects are low. These are the businesses that should be exited when you get reasonable valuations.
- Question Marks: These product lines or segments have high growth but low market share. These are normally where the company management has to focus and work out strategies to improve market share.