Industry and company analysis - Equity risk and return drive...

Learning Outcomes

This article explains industry and company analysis for equity investments, including:

• distinguishing between systematic and company-specific equity risk, and linking each type to required return expectations;
• identifying key industry-level drivers of profitability, growth, and volatility, such as cyclicality, regulation, competition, and technological change;
• applying Porter’s Five Forces to judge industry attractiveness and the sustainability of sector-level returns;
• evaluating how industry positioning (cyclical vs defensive) influences cash-flow stability, earnings risk, and valuation multiples;
• assessing company-specific drivers of risk and return, including business model, cost structure, margins, capital structure, and liquidity;
• analyzing a firm’s competitive advantage using frameworks such as SWOT, and relating these advantages to excess return potential;
• comparing companies within the same industry to identify stronger financial profiles, more resilient strategies, and superior growth prospects;
• integrating industry and company analysis to estimate appropriate risk premiums, screening criteria, and relative valuation conclusions for equities;
• interpreting typical CFA Level 1 question setups and case vignettes involving sector profiles, gearing, and strategic choices.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand how industry and company characteristics affect equity risk and return, with a focus on the following syllabus points:

• Analyze and compare major industry types and factors influencing profitability and risk
• Evaluate the effects of industry structure and competitive forces on company prospects
• Identify key company-specific drivers of equity risk and return
• Assess the financial position and strategy of individual firms within their industry context
• Apply analytical frameworks, such as SWOT and Porter’s Five Forces, to companies and sectors

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which type of equity risk is most closely linked to an investor’s required rate of return in a well-diversified portfolio?
   1. Company-specific (idiosyncratic) risk
   2. Liquidity risk of a single stock
   3. Systematic (market) risk
   4. Accounting policy risk
2. According to Porter’s Five Forces, which factor would most likely increase the long‑term attractiveness of an industry?
   1. High bargaining power of buyers
   2. Low threat of new entrants
   3. Many close substitute products
   4. Intense rivalry among existing competitors
3. Two firms operate in the same cyclical industry. Compared with Firm X, Firm Y has higher fixed operating costs, higher debt, and more volatile earnings. Which statement is most accurate?
   1. Firm Y’s equity should have lower required return because higher debt boosts ROE
   2. Firm Y’s equity should have higher required return due to higher operating and financial risk
   3. Both firms should have the same required return because they are in the same industry
   4. Firm X’s equity should be riskier because it has lower fixed costs
4. When valuing equities, how can an analyst best incorporate findings from industry and company analysis?
   1. By ignoring macroeconomic conditions and focusing only on historical earnings
   2. By adjusting required returns, growth assumptions, and valuation multiples to reflect risk and competitive position
   3. By assuming all firms in a sector deserve the same P/E ratio
   4. By using only risk-free rates because equity risk is not quantifiable

Introduction

Industry and company analysis is core to equity investment decisions. Understanding what drives share price risk and return allows analysts to identify attractive opportunities and avoid pitfalls. Industry conditions, competitive forces, and company-specific features all influence a firm’s cash flows, growth prospects, and cost of equity capital.

At Level 1, you are expected to recognize how these factors affect risk and return conceptually, rather than to build complex quantitative models. Many exam questions describe an industry (for example, regulated utilities or luxury goods) and several companies within it. You must then infer:

• which stocks are riskier or more defensive,
• which firms are better positioned to sustain profitability,
• and which should have higher or lower required returns and valuation multiples.

Key Term: Systematic risk
Risk that affects all companies to some extent, related to overall market or economic factors, such as interest rates, inflation, or business cycles.

Key Term: Company-specific risk
Risk arising from characteristics and events unique to the firm or a narrow segment, such as management decisions, product failures, legal disputes, or company-specific financial gearing.

Key Term: Equity risk premium
The expected return on equities above the risk‑free rate, compensating investors for bearing systematic risk in the stock market.

A key theme throughout the curriculum is the risk–return trade-off: in efficient markets, higher expected return is compensation for higher risk. Industry and company analysis helps you understand what kind of risk you are taking and whether the expected return is adequate.

Understanding Equity Risk: Systematic vs. Company-Specific

Equity risk is the chance that an investment’s return will differ from expectations. It is commonly separated into two broad types: systematic risk and company-specific (idiosyncratic) risk.

Systematic (Market) Risk

Systematic risk is sometimes called non‑diversifiable risk or market risk. It arises from broad economic and financial factors that affect most securities:

• changes in interest rates and monetary policy,
• inflation shocks,
• recessions and expansions,
• political instability or major geopolitical events,
• global financial crises.

Because these influences affect most assets together, they cannot be diversified away by simply holding more securities. Diversification can reduce the impact of any one stock, but if interest rates rise sharply, almost all equities are affected.

From a portfolio standpoint:

• Total risk of a stock can be decomposed as
  total variance = systematic variance + company‑specific variance.
• In a well-diversified portfolio, most company-specific variance is eliminated.
• The required return on a stock therefore depends primarily on its systematic risk (its sensitivity to market or economic factors).

This is the logic behind asset pricing models such as the CAPM, which link a stock’s required return to its exposure to market movements.

Company-Specific (Idiosyncratic) Risk

Company-specific risk—also called nonsystematic, diversifiable, or idiosyncratic risk—arises from factors unique to a firm or small group of firms:

• losing a major customer,
• a failed product launch or drug trial,
• fraud or accounting irregularities,
• poor strategic decisions,
• plant accidents or lawsuits.

Because these events are largely independent across firms, investors can diversify this risk by:

• holding many stocks across different industries and regions,
• avoiding concentration in a few names or a single sector.

The curriculum emphasizes that, in an efficient market, investors are not compensated with a higher expected return for taking on idiosyncratic risk. Rational, risk‑averse investors diversify it away at low cost. Required returns therefore mainly compensate for systematic risk.

This has two key implications for industry and company analysis:

• Industries or firms that are more sensitive to macro factors (for example, highly cyclical sectors) should have higher required returns.
• Firm‑specific weaknesses (for example, a weak brand) increase total risk for a concentrated investor, but do not justify a higher expected return in a fully diversified portfolio. They are still important to analyze because they increase the chance of permanent loss if the problems are severe.

Industry Analysis: Key Profit and Risk Factors

Why Industry Analysis Matters

Companies in the same sector often face similar opportunities and constraints. Industry conditions have a significant effect on profitability and the variability of returns. For example:

• Most airlines suffer when fuel prices spike or when recessions reduce travel.
• Most utilities benefit from stable, regulated demand but face earnings caps.
• Most semiconductor firms experience booms and busts tied to global electronics demand.

Industry analysis helps you:

• anticipate how revenues and margins will move over the business cycle,
• judge whether high current profits are sustainable,
• compare one company’s prospects realistically with those of its peers.

Major Industry Factors

Key industry-level drivers include:

• Growth potential:
  Is the sector in an early growth stage (for example, renewable energy), mature (household cleaning products), or declining (certain legacy media)? Higher structural growth can support higher valuations, but often with more uncertainty.

• Cyclicality:
  Are sales and profits strongly tied to the business cycle?

  Key Term: Cyclical industry
  An industry whose performance is strongly tied to the overall economy, rising in expansions and falling in recessions.

  Cyclical examples: autos, construction, luxury goods, capital equipment, basic materials.

  Key Term: Defensive industry
  A sector with relatively stable revenues and profits across the business cycle, such as utilities or consumer staples.

  Defensive examples: utilities, healthcare essentials, basic food and household products.

  Cyclical industries typically:

  • have more volatile earnings and stock prices,
  • show higher systematic risk (higher betas),
  • should command higher required returns and often trade at lower average valuation multiples (for example, lower P/E at the same growth) than defensive industries.

• Competitive intensity:
  How many major rivals exist? Are there dominant players or is the market fragmented? High rivalry tends to drive prices down and compress margins.

• Barriers to entry:
  Do new firms face high capital requirements, strong brands, patents, or regulatory hurdles? High barriers protect incumbents’ profits.

• Regulation:
  Are prices, profits, or market access controlled by government? Regulation can:

  • limit profits (price caps on utilities),
  • stabilize returns (regulated rates of return),
  • or create risks (sudden policy changes, fines).

• Pricing power:
  Can firms pass input cost increases to customers without losing much volume? High pricing power reduces margin volatility and risk.

• Technological change:
  Does innovation frequently disrupt business models (for example, software, media), or is technology stable (for example, cement production)? High disruption risk can both create opportunities and raise uncertainty.

Assessing Industry Attractiveness: Porter’s Five Forces

The CFA curriculum highlights Michael Porter’s Five Forces framework. This tool helps determine the potential for sector profits and the risks of earnings disruption.

Key Term: Porter’s Five Forces
A competitive analysis framework assessing (1) intensity of rivalry, (2) threat of new entrants, (3) bargaining power of suppliers, (4) bargaining power of buyers, and (5) threat of substitutes.

Briefly:

• Rivalry among existing competitors:
  High rivalry (many similar competitors, slow growth, frequent price wars) usually means lower, more volatile profitability.

• Threat of new entrants:
  If new firms can easily enter when profits are high (low barriers to entry), long‑run returns tend toward normal. High capital needs, regulation, or strong brands can deter entry and support higher returns.

• Bargaining power of suppliers:
  Few powerful suppliers (for example, aircraft manufacturers vs airlines) can demand high prices or favorable terms, squeezing industry margins.

• Bargaining power of buyers:
  If customers are concentrated, price-sensitive, and can easily switch, they force prices and margins down.

• Threat of substitutes:
  If consumers can easily switch to another product solving the same need (for example, streaming instead of cable TV), industry pricing power is limited.

Industries with low rivalry, high barriers to entry, and limited power of suppliers and buyers generally offer more attractive, stable returns than those with the opposite characteristics.

Worked Example 1.1

Suppose an analyst is researching the air travel industry. They observe:

• many competitors (intense rivalry);
• new, low-cost airlines appear frequently (low entry barriers on some routes);
• suppliers (Boeing, Airbus, fuel suppliers) have strong bargaining power;
• buyer power is high, as travelers can easily compare prices online;
• substitutes exist, such as trains or videoconferencing.

Answer:
According to Porter’s framework, the airline industry offers low and volatile returns, with high risk—characteristics confirmed by historical bankruptcies and swings in profitability. Required returns for airline equities should be relatively high to compensate for this systematic and industry‑specific risk, and valuation multiples (such as P/E) tend to be modest even in good times.

Company Analysis: Key Risk and Return Drivers

Even within the same industry, companies differ in strategy, financial structure, and execution. Company analysis helps explain why one firm’s equity might be riskier or more valuable than another’s, holding industry conditions constant.

Company Positioning Within the Industry

Within any industry, companies differ in size, competitive advantage, and robustness. The most important company-level drivers include:

• revenue model and product mix (premium vs mass market, recurring vs one‑off sales),
• cost structure and margins (fixed vs variable costs),
• management strategy and execution quality,
• market share and growth relative to peers,
• financial gearing and liquidity,
• innovation, R&D investment, and technological edge,
• brand, distribution, and marketing strength.

Key Term: Competitive advantage
A unique company position—such as a patented product, powerful brand, network effects, or cost leadership—that allows above-average profitability or below-average risk within the industry.

Companies with durable competitive advantages can often:

• earn higher and more stable margins,
• reinvest at attractive returns,
• withstand recessions better than weaker rivals.

These characteristics lower perceived risk and can justify higher valuation multiples and lower required returns than industry averages.

Cost Structure, Operating Gearing, and Business Risk

A key determinant of earnings volatility is a firm’s mix of fixed and variable operating costs.

Key Term: Operating gearing
The extent to which a firm’s cost structure has fixed costs, making profits sensitive to changes in sales.

When a firm has high operating gearing:

• A small percentage change in sales produces a larger percentage change in operating profit (EBIT).
• In an upswing, profits grow rapidly.
• In a downturn, profits can fall sharply or turn to losses.

This contributes to business risk—risk in operating income due to sales volatility and cost structure.

Firms with:

• high fixed costs (for example, airlines, capital-intensive manufacturers),
• and cyclical demand,

will typically have more volatile earnings and higher equity risk than firms with more variable costs and stable demand (for example, software with low marginal cost but subscription revenues can be less cyclical, depending on client base).

Financial Gearing and Financial Risk

Key Term: Financial gearing
The use of debt (and other fixed-cost financing), which amplifies both return potential and risk to shareholders.

Debt financing introduces financial risk:

• Interest payments are fixed obligations.
• In good times, if the return on assets exceeds the cost of debt, return on equity (ROE) is boosted.
• In bad times, the same fixed interest burden magnifies declines in net income and can lead to financial distress.

Key Term: Return on equity (ROE)
Net income divided by shareholders’ equity, measuring the profit generated for each unit of equity capital invested.

Higher debt levels can therefore:

• increase ROE in normal or good conditions,
• but also increase the volatility of ROE and raise the probability of loss or default.

From a valuation standpoint, if high ROE is achieved mainly through high debt levels (rather than strong margins or efficient asset use), investors may require a higher return and accord the stock a lower P/E or price‑to‑book ratio than a less levered firm with similar ROE.

Key Term: Price-to-book ratio
Market price per share divided by book value of equity per share, reflecting how highly investors value the firm’s equity relative to accounting capital.

A firm with a sustainable, high ROE and moderate risk typically trades at a higher price‑to‑book ratio than a similar firm with low ROE or very high debt levels.

Financial Drivers of Equity Risk and Return

Financial features that affect the risk/return profile of a company’s equity include:

• Profitability:
  Higher and more stable net margins and ROE generally reduce perceived risk and support higher valuations.

• Cash flow stability:
  Firms with volatile or unpredictable cash flows are riskier than those with steady, recurring cash flows (for example, subscription models).

• Operating gearing:
  More fixed costs mean profits are more sensitive to sales swings, increasing business risk and systematic exposure in cyclical industries.

• Financial gearing:
  Higher debt increases potential returns but also risk of losses or distress. Equity in highly levered firms is more volatile and should command a higher required return.

• Dividend policy:
  Reliable, well‑covered dividends can signal financial strength and lower risk, but unsustainably high payouts may increase risk if they weaken the balance sheet.

• Growth opportunities:
  Firms capable of expanding sales, margins, or markets often deliver superior returns, but typically with more uncertainty. The market reflects growth expectations through higher P/E and P/B ratios, especially when high growth is perceived as sustainable and not overly risky.

Key Term: Operating gearing
The extent to which a firm's cost structure has fixed costs, making profits sensitive to changes in sales.

Key Term: Financial gearing
The use of debt (and other fixed cost financing), which amplifies both return potential and risk to shareholders.

Worked Example 1.2

You are comparing two listed homebuilders. Both operate in a cyclical industry. Company A consistently maintains lower debt, keeps cash reserves, and focuses on affordable homes with steady demand. Company B aggressively uses debt for land purchases and targets luxury buyers.

Which stock is likely to show greater share price volatility and risk in a housing downturn?

Answer:
Company B’s higher operating and financial gearing (expensive land, luxury segment), plus more discretionary customer base, suggest its equity should be more volatile and offer a higher required return (risk premium) than Company A’s, even within the same industry.

Worked Example 1.3

Two banks operate in the same market with similar asset mixes and regulation. Recent data show:

• Bank X: ROE = 18%, equity-to-assets ratio = 5%, price‑to‑book ratio = 1.0
• Bank Y: ROE = 12%, equity-to-assets ratio = 10%, price‑to‑book ratio = 1.4

Assume asset quality and management are perceived as similar. How can you interpret the difference in price‑to‑book ratios?

Answer:
Bank X’s higher ROE is largely due to higher use of debt (lower equity‑to‑assets ratio), which increases equity risk. Bank Y earns a somewhat lower ROE but with a stronger capital base and lower financial risk. The higher price‑to‑book ratio for Bank Y suggests investors value its safer, more sustainable earnings stream and are willing to accept a lower expected return (and pay a higher multiple) for lower risk.

Linking Industry and Company Factors—CFA Viewpoint

CFA candidates must be able to link sector and firm features in order to:

• estimate required returns (risk premiums) appropriate for different industries and firms;
• decide whether a stock’s return prospects are justified by its risk profile;
• compare financial health and performance drivers across similar businesses;
• interpret valuation multiples in light of growth and risk.

Conceptually, for any equity:

• required return ≈ risk‑free rate + equity risk premium × (measure of systematic risk).

Industry and company characteristics affect systematic risk and thus the required return:

• Cyclical, capital‑intensive, highly levered firms tend to have high systematic risk and should have higher required returns and lower valuation multiples.
• Defensive, stable‑cash‑flow, low‑debt firms tend to have lower systematic risk and therefore lower required returns and higher valuation multiples, all else equal.

Company-specific weaknesses (for example, poor governance) may not increase systematic risk much, but they still matter because:

• they increase the chance of permanent loss (for example, bankruptcy, dilutive equity issuance),
• they can justify applying a discount to valuation multiples relative to peers.

Worked Example 1.4

An analyst is valuing two stocks. The risk‑free rate is 3% and the expected long‑run equity risk premium is 5%.

• Stock C: defensive consumer staples company, estimated beta ≈ 0.7
• Stock D: cyclical industrial company with high debt, estimated beta ≈ 1.4

Estimate the required return for each stock and relate this to industry and company characteristics.

Answer:
Using a simple CAPM‑style approach:

Required return C ≈ 3% + 0.7 × 5% = 6.5%
Required return D ≈ 3% + 1.4 × 5% = 10.0%

Stock D, in a cyclical and more levered industry segment, has roughly double the systematic risk of Stock C. Investors therefore demand a much higher expected return. In valuation, this higher discount rate will reduce the present value of D’s cash flows and usually corresponds to lower P/E and P/B multiples relative to a low‑risk consumer staples firm like C.

Revision Tip

When given a sector or company profile in a CFA exam question, quickly identify:

• Is the industry cyclical or defensive, and how sensitive is it to the business cycle?
• What do Porter’s Five Forces imply about long‑run profitability and competitive threats?
• Where does the company stand on operating gearing, financial gearing, margins, and growth?
• Does it have a durable competitive advantage, or are profits easily eroded by rivals?
• How should these features affect required return, risk premium, and appropriate valuation multiples?

Summary

Well-structured industry and company analysis is essential for assessing equity risk and return. Systematic (market) risk arises from broad economic forces and cannot be diversified away; it is the main driver of the required return for stocks in well‑diversified portfolios. Company-specific risk, by contrast, is diversifiable but still important for understanding downside scenarios and firm failure.

Industry factors such as growth potential, cyclical sensitivity, rivalry, regulation, and technology shape the typical profitability and risk profile of firms in a sector. Tools like Porter’s Five Forces help you judge whether above‑average returns are likely to be sustainable.

Firm-level drivers—competitive advantage, cost structure and operating gearing, capital structure and financial gearing, profitability (including ROE), and cash-flow stability—explain why one company’s equity may be riskier or more valuable than another’s, even within the same industry. Strong, defensible business models with moderate use of debt support more stable returns and higher valuation multiples; aggressive, highly levered strategies magnify both upside and downside, requiring higher expected returns.

For the CFA Level 1 exam, you should be able to connect these qualitative assessments to practical conclusions about relative risk, expected return, and valuation, especially in case-based questions describing sectors and companies in narrative form.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish clearly between systematic (market) and company-specific (idiosyncratic) equity risk, and understand why only systematic risk is rewarded in expected returns.
• Recognize major industry influences on equity returns and risk, including growth stage, cyclicality, regulation, and the structure captured by Porter’s Five Forces.
• Assess how cyclical versus defensive industry positioning affects cash-flow stability, earnings volatility, and typical valuation multiples.
• Identify company-specific risk drivers: business model, competitive advantage, operating and financial gearing, profitability (margins, ROE), and liquidity.
• Interpret ROE and price‑to‑book ratios in the context of capital structure and growth opportunities, rather than in isolation.
• Link industry and company analysis to realistic equity return estimation (risk premiums), capital costs, and valuation tasks.
• Apply appropriate frameworks such as Porter’s Five Forces and simple comparative analysis to case scenarios for CFA Level 1 questions.

Key Terms and Concepts

• Systematic risk
• Company-specific risk
• Equity risk premium
• Porter’s Five Forces
• Competitive advantage
• Operating gearing
• Financial gearing
• Return on equity (ROE)
• Price-to-book ratio