Learning Outcomes
After reviewing this article, you will be able to analyze the key forces shaping competition within industries, identify and assess growth drivers for companies, and evaluate the presence and sustainability of economic moats. You will understand how to apply these concepts to determine industry profitability and the ability of firms to maintain superior returns. This is core knowledge for the CFA Level 2 exam.
CFA Level 2 Syllabus
For CFA Level 2, you are required to understand and apply theories and frameworks for industry and company analysis. Focus your revision on the following areas:
- Analyzing industry structure and competitive forces using recognized frameworks, e.g., Porter’s Five Forces
- Identifying and assessing industry growth drivers and company-specific growth prospects
- Evaluating the impact and durability of competitive advantages (economic moats)
- Applying industry and company analysis in the context of equity valuation and forecasting
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.
- Which of Porter’s Five Forces would be most directly affected by a high threat of substitute products?
- State two characteristics that increase the sustainability of a company’s economic moat.
- Suppose a new regulatory policy lowers barriers to entry in an industry. How would this most likely affect the long-term profitability of established firms?
- What is meant by 'switching costs,' and which competitive force do they primarily affect?
Introduction
Analyzing industry forces and company positioning is fundamental to equity valuation. A company’s ability to generate superior returns depends not only on its internal strengths but also on the structure and forces of the industry in which it operates. Industry competition, growth drivers, and the presence of robust economic moats determine whether a firm can sustain above-average profitability. Command of these concepts is essential for the CFA Level 2 exam, where you will be required to assess investment prospects and forecast company performance.
Understanding Industry Structure: Porter’s Five Forces
Industry profitability is shaped by the intensity of competition, which can be systematically examined using Porter’s Five Forces framework. This model helps identify the sources of value and risk within any industry by assessing the following competitive pressures:
Key Term: Porter’s Five Forces
A framework evaluating five sources of competition—threat of new entrants, bargaining power of suppliers, bargaining power of buyers, threat of substitutes, and intensity of rivalry—which collectively determine industry profitability.
- Threat of new entrants: High barriers to entry reduce the risk of new competitors eroding existing profits. Barriers can include regulation, brand loyalty, economies of scale, and capital requirements.
- Bargaining power of suppliers: Powerful suppliers can demand higher prices or better terms, squeezing industry margins.
- Bargaining power of buyers: Powerful customers can force down prices or demand higher value, undermining profitability.
- Threat of substitute products or services: The presence of alternatives places a ceiling on prices and limits market power.
- Intensity of competitive rivalry: Widespread rivalry can result in price wars, increased marketing costs, and reduced industry returns.
Industry Evolution and Cyclicality
Industries progress through various life-cycle stages—introduction, growth, maturity, and decline—each with distinct growth drivers and competitive forces. Cyclicality refers to the degree to which industry demand fluctuates with macroeconomic cycles, affecting forecasting and valuation.
Key Term: Industry cycle
The sequence of development stages through which an industry typically passes: introduction, growth, maturity, and decline.
Key Factors Affecting Industry Attractiveness
Factors such as industry concentration, capital intensity, product differentiation, excess capacity, and switching costs influence the power of each force. Highly concentrated industries with strong barriers tend to be more attractive for sustaining above-average returns.
Company-Specific Growth Drivers
A company’s ability to achieve long-term growth depends on both industry-level and firm-specific factors.
- Industry growth: Driven by macro trends (GDP, demographics, technology, regulation).
- Company growth drivers: Innovation, operational efficiency, access to capital, and effective strategy.
Sustainable Growth and Forecasting
Long-term growth rates are rarely above the broader economy’s growth unless supported by unique advantages. Evaluate sources of growth carefully for reasonableness and sustainability in financial models.
Worked Example 1.1
Question: You are analyzing a telecommunications company with a patented technology generating faster data speeds than competitors. How does this affect its competitive position?
Answer:
The company’s patented technology establishes a temporary barrier to entry, reducing the threat of new entrants. This enhances its market position and supports above-industry-average profitability, at least until rivals catch up or the patent expires.
Economic Moats: Assessing Durable Competitive Advantage
Economic moats describe factors that protect a company from competitive threats, enabling it to consistently earn returns above its cost of capital.
Key Term: Economic moat
A structural, durable advantage that shields a company from competition and secures its long-term profitability.
Common sources of moats include:
- Cost advantages: Lowest cost producers can survive price competition.
- Intangible assets: Brands, patents, licenses, or regulatory advantages limit competition.
- Network effects: The value of a product or service increases as more people use it, discouraging rivals.
- Switching costs: High customer switching costs lock in clientele (e.g., enterprise software systems).
- Efficient scale: Niche markets dominated by a single or a few players discourage entry.
Key Term: Switching costs
Costs incurred by customers when changing suppliers, making them less likely to switch and reducing competitive pressure.
Evaluating the Durability of Moats
Not all competitive advantages are sustainable. Scrutinize whether a company’s moats are likely to endure disruptive innovation, regulatory change, or shifts in consumer preference. Moats must be continuously reinforced through innovation, customer loyalty, and cost leadership.
Worked Example 1.2
Question: A large utility company is the sole provider of water in its region and heavily regulated. What forms of moat does it possess?
Answer:
The company benefits from efficient scale (natural monopoly), high capital requirements, and regulatory protection—resulting in minimal threat from both new entrants and substitutes. These characteristics support stable excess returns, subject to regulatory oversight.
Exam Warning
Do not assume that any competitive advantage is permanent. On the exam, carefully consider the risk that new technology, changes in regulation, or changing customer needs could erode moats or alter industry structure.
Applying Industry and Company Analysis
For effective company analysis:
- Review current and projected industry conditions, including the Five Forces.
- Examine company positioning, specific growth initiatives, and the sources and threats to its moats.
- Consider management quality, resource access, and adaptability.
Industry and company analysis informs revenue forecasts, cost structures, and ultimately valuation—critical skills tested in CFA Level 2 equity and credit analyses.
Key Point Checklist
This article has covered the following key knowledge points:
- Use Porter’s Five Forces to evaluate industry profitability and competition.
- Recognize industry growth drivers at both the macro and company levels.
- Distinguish cyclical from structural growth in company forecasting.
- Identify and assess economic moats and their sustainability.
- Analyze switching costs as a key barrier to customer attrition.
- Apply industry and competitive analysis to valuation and forecasting.
Key Terms and Concepts
- Porter’s Five Forces
- Industry cycle
- Economic moat
- Switching costs