Now that we’ve passed our first reflection point, it’s time to start digging in and doing some real due diligence on your company.
Note, Steps 2 and 3 (industry and company analysis) should really be done in unison. What do I mean by that? You should start by briefly researching your company’s products/offerings just to get a basic understanding of what it does. That way, you can effectively understand the industry it operates in.
I personally recommend doing a deep dive into your company’s industry before you deep dive into your company analysis. It is very difficult to understand a company’s performance and fundamentals if you don’t understand the industry(ies) it operates in. For that reason, I like to start at a macro level (industry analysis) and then work down to the micro (company analysis) level.
With that in mind, let’s get started.
Why am I Doing This?
You might be wondering, what is even the point of researching the industry? The entire purpose of doing research on the industry your company operates in is to understand two key points:
- What is the profit potential of your company based on its industry?
- How risky is your company based on the industry it operates in?
- What is the current industry size in terms of revenue?
- What are the growth prospects for the industry?
Remember, the industry should tell you the profit potential of your company based on current participants (or future participants). It should also give you the likelihood of your company reaching a strong position market, as well as its likelihood of maintaining that position.
If you don’t understand your company’s likelihood of success, nor its profit potential, how are you going to be able to properly value it?!
I feel like this is an often glossed over step in the microcaps. For example, I’ll see people boasting about how a company is going to rake in cash and make all of this money, but they operate in an industry where every mature company is earning razor thin margins. You aren’t going to break into an industry like groceries and expect to earn margins like Apple. It’s not gonna happen.
Now, with that in mind, onto the steps for analyzing your company’s industry.
Define the Industry
First, take some time to briefly research your company’s product offerings, services, etc. and we can then define what industry we’re talking about.
The first place to generally look is the company’s most recent 10k or annual report. There is always a section discussing the company’s opinion of which industry they operate in. So, I would first and foremost use this as the defined industry for your company.
However, as per the rules of the road, always be skeptical of management. You’d be surprised how many companies just copy and paste the same thing each year even if there’s been a business change, new offering, etc. This is why I recommend having some healthy critical thought here and just double checking the products/services match the industry they say they’re in.
The second step is to make sure you have the scale of your industry calibrated correctly. Let’s give an example. Take a relatively small-time lithium battery company on the OTC that you’re interested in. You could say they’re in the electronics industry at a macro level. But is that meaningful? Think about how many different types of companies are in the electronics industry.
You then move down a level and then say, okay they’re in the batteries industry. That’s a level down from electronics, right? But, again, think about the sheer amount of diversity within the batteries industry. Are we talking about alkaline, lithium, etc.? What about rechargeable? Single use? Are these consumer batteries for people’s TV remotes? Are these electric vehicle batteries?
You get the idea.
In general, you want to try and narrow down your industry scope to be as narrow as possible. This is completely dependent on the level of industry data you can find, which we will get to next, but don’t get lazy with how hard you search for industry data.
Locate Industry Research
This is something I cannot give a perfect answer for as it largely depends on your access to research resources/googling ability, and the amount of available information by industry. But in general, my favorite thing to do is literally just google “XXX industry analysis” in google. You would be surprised how much info is free, or partially free, these days.
If possible, try to locate a minimum of three separate sources. Sometimes you’ll find that they vary quite extremely in terms of key metrics and information provided.
Now that you have your sources, now what?
Key Industry Data – The Basics
This goes without saying, and you’ll pick a lot of this up below. But as a bare minimum starting point you need to know who the top five companies are in the industry in terms of market share. You also need to know the top five product types and or offerings, plus associated brands (if necessary). This will come with research though.
You should also make yourself aware of any general industry trends, and just generally where the industry is headed. For example, if you’re researching the automotive industry and you don’t even look into electronic vehicles, you’re setting yourself up for failure. Every industry is constantly evolving. Your company might be a leader in innovation in the industry, or it might be stuck in the past. Either way, you need to know the difference.
Like I said, most of this will be picked up as you research the next topic…
Key Industry Data – Fundamentals
I am a strict follower of the “Porter’s Five Forces Analysis” technique for understanding an industry. I highly recommend you read other articles which describe it. But I’ll give you a brief rundown here.
Essentially, this guy named Michael Porter wrote a paper in the 1980’s which is a widely accepted method for analyzing an industry. What you do is define five “forces” of an industry which help the researcher determine how competitive an industry is. Once you’ve defined these, you can try to quantify the questions I asked in the introduction.
He defines these five competitive forces as:
- Competition
- Potential of new entrants
- Supplier power
- Consumer power
- Threat of substitutes
I’ll get into each of these briefly.
Competition
This is, put shortly, how competitive each of the current industry participants are with each other. This is loosely defined as how aggressively each of the current participants seek to undercut each other to increase market share. In general, the less competition there is between current players, the higher margins are, and the less willing companies are to undercut.
Potential of new entrants
This is defined as the ease of new players to enter a market. In general, the easier it is to enter a market, the higher the competitiveness of the market. A company cannot command high profit margins and still expect to keep market share if a new entrant could join the industry in three months at minimal cost and undercut the current players.
Conversely, if you take an industry like a utility, it is extremely difficult to join that market. Think of your local electric utility. Then think of how hard it would be to build up the infrastructure to be able to service all of their customers, procure the necessary power, etc. It would be next to impossible. Utilities, for this reason, are seen as a safe investment with steady, generally high, profits which are highly regulated by local governments.
Supplier Power
This is defined as the power dynamic between industry players and their suppliers. The power dynamic works both ways. If a company is able to choose its suppliers freely and its suppliers are in a hyper-competitive market, you would say the company has high power over its suppliers. Generally, the more suppliers, the more power the company has.
A great converse example of this is the current situation with computer chips. A company like Taiwan Semiconductor, or any other chip manufacturer, currently has extreme supplier power over its customers – basically any company that needs chips. Any company that is extremely reliant on chips, right now, would be said to have low power over its suppliers.
In general, less power over your suppliers means lower profit margins, and vice versa. Low power tends to increase your costs of production as suppliers are taking more profit out of the supply chain.
Consumer Power
The concept of consumer power refers to how much power your consumers have over the company. In general, it means that if your company’s customer base is very small and is reliant on one or two key customers, your customers have significant power over you. The more power your consumers have over you, the lower your ability to increase prices and improve revenue and margins. It also refers to the cost to find new customers if needed.
A great example of this is military contractors. They have usually one customer, the government, and are completely at their whim. They are totally reliant on repeat contracts. Even if there are consistent contracts in place, many companies (not named Boeing or Raytheon) will have serious profitability issues. Any person in the military below Major will tell you that “Military-Grade” means the lowest possible bidder 😊.
Threat of Substitutes
This concept is pretty self-explanatory, but it refers to the idea of substitute goods. A substitute is any other product or service that can be used in place of yours. Think of things like lemonade instead of Coke, a scooter instead of a bike, etc.
The more substitutes there are for your products, the less pricing power you have, and vice versa.
Remember, this not the same as substitutes within your product line. For example, a substitute is not substituting one brand of bike for another. That level of competition is covered in the “Competition” force.
Five Forces Wrap Up
Now, you’ve done your research and have a good idea of the level of competition in each of the above forces. What do you do with it?
Generally, I like to give each of the five a score from 1-5, with one being the least competitive, and five being the most competitive. Add them all up and you get a number between five and twenty-five.
Now, you can refine this later obviously, but just to give you an idea of a ballpark level of profitability, treat that number you got as an operating margin (operating income / net revenue). So if you scored a 15, you should expect around 15% operating profit margins when your company is fully mature and is a legitimate player in the industry.
Remember, this is a microcap analysis, so the idea is that your company is not a major player right now, but your hope is that one day they will. So keep that in mind.
Key Industry Data – Growth and Size
While the five forces analysis generally tells us profit potential and general risks associated with a company operating in an industry, it doesn’t really tell us much about the size and/or growth prospects of an industry.
These are crucial pieces of data for your upcoming forecasts, or even if you think the company is worth further investigating. If you’re hoping for your company to be a big growth company, tons of revenue gains annually, high profits, but it’s in the fax machine business… you may need to rethink your estimates.
Luckily, most of the sources you provide online will give you typically a current revenue size for the industry as well as the forecast growth of the industry for the next 5-10 years.
Those two key pieces of info, revenue size and growth for the industry, are what you need to focus on here. These will be key pieces of information as you factor in the growth of your company when it reaches a mature stage as well as during its growth stage.
Wrap Up
This was a bit of a dense article, but to sum it up…you need to research your company’s industry to help you understand:
- What is the profit potential of your company based on its industry?
- How risky is your company based on the industry it operates in?
- What is the current industry size in terms of revenue?
- What are the growth prospects for the industry?
These will be extremely key reference points as we move into the company analysis, as well as your financial statement analysis and growth prospects. These will give you insights into how your company could grow, how much profit it could earn, and the likelihood of success. If you don’t understand an industry your company operates in, how can you understand the company!
Next, we’ll get into the company analysis, which is my favorite step 😊.
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DISCLAIMER – THIS ARTICLE IS NOT FINANCIAL ADVICE AND IS INTENDED ONLY FOR EDUCATIONAL PURPOSES. I AM NOT A FINANCIAL ADVISOR. DO YOUR OWN RESEARCH.
Nice article.
Discipline, discipline, discipline as in location, location, location.
Thank you.