The Importance of Industry Research

Understanding the different aspects of an industry is key to evaluating a company’s future performance

Understanding a subject entity’s industry is a hallmark of any good valuation report. Conducting a very detailed and intense industry analysis can provide valuation analysts with specific knowledge needed to determine an appropriate conclusion of value. As a general rule, a company’s performance is commensurate with the industry to which it belongs. Understanding the different aspects of an industry is a key component to evaluating future performance and the overall value of a company. This is an aspect of business valuation that warrants greater attention from valuation professionals.

Oftentimes, the industry outlook section of a business valuation report is overlooked and not given the proper attention it deserves. Appropriately analyzing a company’s industry has many useful applications. First and foremost, a valuation analyst should understand a subject entity’s industry to determine whether he or she can reasonably expect to perform the valuation engagement with professional competence. A poor understanding of a company’s industry is a legitimate reason to decline an engagement.

Industry research and analysis is applicable when reviewing both nonfinancial and financial information during the course of a valuation engagement. Nonfinancial industry data that needs to be considered include industry performance, industry outlook, environmental concerns, supply chains, products and/or services offered, competitive landscape, and capital intensity, to name a few. These considerations assist in determining (and defending, if necessary) projected growth rates, capital requirements, discount rates, and the discount for lack of marketability.

There are a number of items to consider when researching industry performance. They include external competition, current performance, industry restructuring, trends, and regulations. The industry outlook is important because it gives the reader of a valuation report an idea of where a company may be going in the next three to five years. This information is not only useful in forecasting, but it allows for analyzing a company with respect to economic indicators such as a recession, rising employment, consumer expenditures, etc. Environmental concerns can be a material factor if there is a major concern in a particular industry. This may impact future capital investment and cash flow. A valuation analyst should, if possible, evaluate a subject entity’s supply chain and understand the interplay between a company and both their key buying (e.g. vendors) and selling (e.g. customers) industry participants. Perhaps the most important consideration is a company’s product/service segmentation and understanding how it relates to their industry. This gives the valuation analyst knowledge about a company’s main source of revenue, opportunities for growth, and concentration level. All factors described in this paragraph are key drivers in determining revenue volatility.

An industry’s competitive landscape offers important information regarding cost structure benchmarking, competition, and barriers to entry. Understanding cost structure benchmarks of an industry helps a valuation analyst to compare a subject entity’s profit margin against industry norms. Competition can be broken down by geographic location to further analyze the number of companies competing and whether internal and/or external competition exists. Internal competition may include price, location, quality of service, and extra services offered. External competition mainly includes any sort of cheaper alternative available to a consumer. A valuation analyst should consider and make a checklist of the following factors when determining an industry’s barriers to entry: competition, concentration, life cycle stage, capital intensity, technology change, regulation, and industry assistance.

Most valuation reports of operating entities include analytical procedures as part of the financial analysis. This includes analyzing liquidity, profits and profit margins, sales, debt, and assets. In addition to performing a financial analysis of a subject entity, a valuation analyst should obtain financial information specific to the subject entity’s industry (if available). This includes comparative common size industry financial information for the relevant time period. It is important to compare and benchmark the performance of a subject entity with competitors and industry trends and norms. This comparison between a subject entity’s financial performance and the financial performance of the subject entity’s industry as a whole is a good indication of the overall health of a company.

Analyzing a subject entity’s industry also assists with determining an appropriate discount rate. There are three main types of industry risk to consider. Those three industry risks are: structural risk, growth risk, and sensitivity risk. Structural risks include such components as barriers to entry, competition, supply/demand, revenue volatility, and life cycle stage. Growth risk evaluates forecasted industry growth against past performance of a subject entity. Sensitivity risk evaluates the most significant external factors affecting an industry’s performance. For example, components of sensitivity risk may include per capita disposable income and the national unemployment rate. These items are very general, but there may be components of sensitivity risk applicable to a certain industry which should be considered.

Understanding a subject entity’s industry is a hallmark of any good valuation report. Conducting a very detailed and intense industry analysis can provide valuation analysts with specific knowledge needed to determine an appropriate conclusion of value. As a general rule, a company’s performance is commensurate with the industry to which it belongs. Understanding the different aspects of an industry is a key component to evaluating future performance and the overall value of a company. This is an aspect of business valuation that warrants greater attention from valuation professionals.

Lawrence A. Horwich, CPA, CVA, ABV, is the managing partner of Horwich Coleman Levin, LLC, a Chicago-based firm (www.horwich.com). He has over 30 years of experience in public accounting as well as business consulting, auditing, taxation and estate planning. He performs valuations of private, closely held businesses and emerging companies for sale, mergers and acquisitions, financing, (debt and/or equity) for estate and gift tax purposes, shareholder disputes, buy-sell agreements, insurance claims, marital situations and other business matters. Larry can be reached at lah@horwich.com.

Co-authored by David Elyashar, CVA, CPA. David has expertise dealing with income tax matters in the financial services industry, specifically with private equity firms and hedge funds. He is also specializes in tax and estate planning, audit and accounting and financial/investment services. Mr. Elyashar is a Certified Valuation Analyst (CVA) and is well-versed in business valuation and litigation support. He performs valuations of private, closely held businesses and emerging companies for sale, mergers and acquisitions, financing (debt and /or equity), estate and gift tax purposes, shareholder disputes, buy-sell agreements, insurance claims, marital situations and other business matters. David can be reached at dje@horwich.com.