Industry size, growth, profitability and concentration

How big is the industry: top-down or bottom-up?

Industry size is the total revenue the industry earns from its own goods or services over a period. There are two ways to estimate it. Top-down takes a total for the whole industry from a statistics agency or a data provider. Bottom-up adds up what each participant earns from the industry’s own goods and services.

• Top-down approach : an estimate of total revenue across the whole industry over a period, usually published by a government statistics agency or a reputable data provider (retail sales statistics are a common example). Its weakness: the published categories may not be fine enough to separate the industry you want from its neighbors.
• Bottom-up approach : the sum of the revenue each participant earns from the specific goods or services, not the sum of their total revenues. A carmaker’s insurance arm, for instance, does not count toward the size of the car industry. It works best when a few large listed companies dominate and report clear segments. It struggles when many private companies hold real share (little or no data) and when companies in several industries report their segments differently.

When firm-level data make bottom-up impractical, for example in an industry of thousands of small businesses, analysts use top-down figures: government indicators, consultancy surveys, or industry data in companies’ investor presentations.

Who has the market share?

Market share is the percentage of total industry sales a company generates over a period: its revenue from the industry’s goods or services divided by the industry’s size.

$$s = \frac{\text{company revenue from the industry}}{\text{industry size}}$$

Because the industry size is itself an estimate, read shares as a range rather than a single number. Big changes in share over time, or newcomers winning share, signal intense rivalry among competitors. Check whether share moved through mergers and acquisitions or organically, from customers’ choices: buying a competitor adds share overnight, but what matters is whether the company is gaining share organically.

Is it a growth or a mature industry?

Compare the industry’s growth with the whole economy over a full cycle. Growth industries grow faster than the economy whatever the cycle; mature industries grow near or below it and may be cyclical or defensive.

Across all industries together, growth must equal the economy’s growth. A mature industry has already reached most of its potential customers, so it grows at or below the economy’s rate. The questions for investors: disruptive threats, changes in competitive intensity, and when decline might start and how fast it would be. Sensitivity to the cycle is higher where sales are discretionary, where products are consumer durables or capital goods, and where revenue depends on interest rates.

A growth industry grows faster than the economy and is usually not sensitive to the cycle, because it has not yet reached full penetration of its total addressable market , the revenue it could earn if every potential customer bought. The questions: how long above-trend growth will last, and the expected peak penetration rate. Both are harder to judge the earlier the industry is.

Structural changes in demand and severe shocks can also change an industry’s growth: think of how a sudden border closure would hit travel while lifting online shopping.

Industry growth versus the economymeasured over a full cycle

• Growth industry Memorize faster than the economy, not cycle sensitive
  • Key questions how long, and peak penetration
• Mature industry Memorize near or below the economy
  • Cyclical discretionary, durables, capital goods, rate-sensitive
  • Defensive essentials, steady demand
  • Key questions disruption, competitive intensity, decline

Sensitivity to the business cycle comes from the business models in the industry.

Sensitivity to the business cyclehigher for discretionary, durable and rate-sensitive sales

• Discretionary versus necessary sales Memorize purchases that can wait are cyclical
• Interest rate exposure of the business model Memorize credit-funded purchases and borrowers
• Durable or capital goods versus recurring purchases Memorize consumables and subscriptions are steadier

Exam tip A mature industry can still grow, and it can be cyclical or defensive. A growth industry is the one that grows fast whatever the cycle.

How profitable is the industry?

Memorize

Use operating profit margin or return on invested capital (ROIC). Both leave out gains, losses and non-operating income that distort net profit. Then compare ROIC with the weighted average cost of capital (WACC), the return investors require.

Operating profit margin is operating income as a share of total revenue.

$$\text{Operating margin} = \frac{\text{Operating income}}{\text{Total revenue}}$$

Return on invested capital (ROIC) is the after-tax operating profit earned on the capital that lenders and owners have put into the business.

$$\text{ROIC} = \frac{\text{NOPAT}_t}{\text{Average invested capital}}$$

In the formula, $\text{NOPAT}_t$ is net operating profit after taxes (NOPAT); invested capital is total long-term liabilities plus equity, averaged between the start and the end of the period. This is the same ROIC as in Corporate Issuers.

ROIC above WACC means the industry earns an excess accounting return .

$$\text{ROIC} - \text{WACC} \quad \text{or} \quad \frac{\text{ROIC}}{\text{WACC}}$$

ROIC covers both debt holders and shareholders, so the right comparison is WACC, not the cost of equity. It is the whole-firm version of return on equity minus the required return on equity, $r_e$, in residual income valuation. Analysts often follow it as a time series, and sometimes as the ratio ROIC ÷ WACC, where above 1 means value is being created.

One good year proves little. Look at the ratio over a full cycle, and at how it is spread across firms: an industry average just above 1 can hide two firms well above it and several below.

For private companies, analysts either assume they look like the public ones or use government or consultancy surveys of margins and costs.

How concentrated is the industry?

Industry concentration says how much of the industry sits with a few firms. Lower concentration usually means more intense competition, unless the industry is split into local segments or its products are highly differentiated. Rising concentration through consolidation usually means less intense competition and higher profitability.

The usual measure is the Herfindahl-Hirschman Index (HHI) , introduced in Economics: the sum of the squared market shares of the firms in the industry.

$$HHI = \sum_{i=1}^{n} s_i^2$$

Shares go in as whole numbers: a 50% share is 50, not 0.50. A monopoly scores 100² = 10,000; equal firms score 10,000 ÷ n. Regulators in some countries treat an industry with an HHI above 1,800 as highly concentrated, and a proposed merger that raises the HHI by more than 100 points in such a market gets closer scrutiny and may be challenged.

The change from a merger depends only on the two firms that merge, because squaring (a + b) adds an extra term 2ab.

$$\Delta HHI = 2\,s_A\,s_B$$

Merging the two 10% producers instead adds 2 × 10 × 10 = 200, taking the HHI to 2,650: still twice the 100-point line. Any merger raises the HHI, and the bigger the merging firms, the bigger the jump.

Why the HHI depends on how you size the industry

A gap between the top-down total and the bottom-up sum is itself information: here listed firms hold only 62.5% of the industry, so many small competitors remain.

Industry surveystep 2 of industry and competitive analysis

• Size Memorize top-down or bottom-up
  • Top-down statistics agency or data provider
  • Bottom-up members' revenue from the industry only
• Growth Memorize compared with the economy over the cycle
• Profitability Memorize operating margin, ROIC against WACC
• Market shares and concentration Memorize organic versus acquired; HHI

Go deeper Why industry size is often an estimate

Where small and private firms make up much of an industry, no one counts their sales exactly. Analysts triangulate: a government census of businesses, a consultant’s survey and the investor presentations of large players. When three sources land close to each other, confidence rises. When they do not, say so and treat the size, and therefore every market share, as a range.

Go deeper Why a share bought by acquisition says little

A company that buys a rival adds the rival’s share overnight, but its own products have not become more attractive. Organic share, the change excluding acquired sales, shows whether customers are choosing the company. Also watch for a disruptive entrant: a pioneer that wins a large share of a new channel is a threat to the established players even while they still hold most of the total.