CFA Level I · CFA Level I Exam

Industry and Competitive Analysis: formula sheet

Full chapter guide

Key formulas

Principal business activity rule: Classification = activity generating the largest share of revenue (earnings and market perception as supporting evidence); Commercial systems classify the whole company into one category using this rule.
GICS hierarchy: Sector → Industry group → Industry → Sub-industry; Four levels, broad to narrow.
ICB hierarchy: Industry → Supersector → Sector → Subsector; Four levels, broad to narrow.
Commercial vs government purpose: Commercial (GICS, ICB) = investment analysis; Government (NAICS, ISIC) = economic statistics; Government systems cover private firms as well as public ones, and classify by establishment.
Peer group test: Peers = similar business activities + similar demand drivers + similar cyclicality + similar financial profile; Classification is only the first screen; always confirm with these criteria.
Embryonic stage traits: Slow growth + high prices + high costs + few rivals + losses + high failure risk; The product is new and unproven. Customers are few and firms spend heavily to build awareness.
Growth stage traits: Rapid growth + rising profits + falling costs + new entrants; Scale economies and rising demand improve margins. Competition increases.
Shake-out stage traits: Slowing growth + excess capacity + price competition + falling margins + exits; Cost structure decides who survives. Weak firms fail or are acquired.
Mature stage traits: Slow growth near the economy + stable pricing + few large firms + high barriers; Firms focus on efficiency and market share. Growth often comes from acquisitions.
Decline stage traits: Falling demand + excess capacity + price pressure + exits and consolidation; Causes include substitutes, changing tastes and technology. Some firms harvest cash.
Rivalry is intense when: Many or equal-sized competitors + slow industry growth + high fixed costs + low differentiation + high exit barriers; These conditions push firms to compete on price. The opposite conditions make rivalry mild.
Threat of entrants is high when: Low barriers: little scale advantage, low capital needs, easy distribution access, weak brands, low switching costs, no regulatory limits; High barriers (economies of scale, strong brands, patents, licences, high capital needs) reduce the threat.
Threat of substitutes is high when: Close substitutes exist + low switching cost + substitute offers better price-performance; Substitutes limit the price ceiling for the whole industry.
Buyer power is high when: Few buyers or large purchase volumes + standardized product + low switching costs + buyers can integrate backward + buyers are price sensitive; Buyers' power rises when they are concentrated and the product is undifferentiated.
Supplier power is high when: Few suppliers + unique or differentiated inputs + high switching costs + no substitute inputs + suppliers can integrate forward; Suppliers gain power when the industry is not an important customer for them.
Overall conclusion: Stronger forces → lower profit potential and pricing power; weaker forces → higher profit potential; The framework describes industry attractiveness, not any single firm's results.
N-firm concentration ratio: CRN = sum of market shares of the N largest firms; Common choices are N = 4 or 5. Easy to compute but ignores the split among the top firms and the small firms.
Herfindahl-Hirschman Index (HHI): HHI = Σ (sᵢ)², with shares sᵢ in percent (or as decimals); Include all firms if data allow, or the top N firms if that is what the question gives. With percent shares, a monopoly scores 10,000. With decimal shares, it scores 1.
HHI for N equal-sized firms: HHI = 1 ÷ N with decimal shares, or 10,000 ÷ N with percent shares; Four equal firms give 0.25 with decimal shares, or 2,500 with percent shares.
Pricing power ranking: Monopoly > Oligopoly > Monopolistic competition > Perfect competition; Oligopoly can vary, since price wars or collusion change outcomes.
Profit-maximizing rule: Produce where marginal revenue = marginal cost; Perfect competition: price = marginal revenue. Other structures: price is above marginal revenue.
External factor checklist: Macroeconomic + Technological + Demographic + Governmental + Social; Use it to classify any external influence in a question. Environmental and legal issues usually fall under social or governmental.
Cyclical industry test: Demand highly sensitive to income and credit, purchases postponable → cyclical; Typical examples: autos, housing, luxury goods, capital equipment, airlines.
Defensive industry test: Demand for necessities, low sensitivity to income → defensive; Typical examples: food, utilities, healthcare, household staples.
Growth industry test: Expansion driven by structural change, faster than the economy over the long run; Growth is not the same as cyclical or defensive. Check what the question is asking.
Profit sensitivity: Higher fixed costs (operating leverage) → profits swing more than sales; Adds to cyclicality for industries such as airlines and steel.
Cost leadership profit logic: Profit margin advantage = (Price − Unit cost) vs the industry average; A cost leader earns more per unit at the industry price, or matches rivals at a lower price.
Differentiation profit logic: Premium earned > Extra cost of differentiation → higher margin; If the premium is smaller than the added cost, differentiation destroys value.
Gross margin: Gross margin = (Revenue − Cost of goods sold) ÷ Revenue; Persistently high gross margin versus peers suggests differentiation or pricing power.
Operating margin: Operating margin = Operating income ÷ Revenue; A low-cost firm may show lower gross margin but strong operating margin from low overhead.
Value creation test: Return on invested capital (ROIC) > Cost of capital; A sustainable competitive advantage shows up as ROIC above cost of capital over time.

Quick revision

Classify a company by its principal business activity, usually the source of most of its revenue.
Peer groups should share similar business activities, demand drivers, cost structure and exposure to the economy.
Life cycle stages: embryonic, growth, shakeout, mature, decline.
Growth stage: fast sales growth, new entrants, margins improving as scale builds.
Shakeout stage: growth slows, competition rises and weaker firms leave.
Mature stage: slow growth, stable share, pricing and cost discipline matter.
Porter's five forces: rivalry, threat of new entrants, threat of substitutes, buyer power, supplier power.
Stronger forces mean lower profit potential for the industry; weaker forces mean higher.
High barriers to entry and few competitors support pricing power.
Cyclical sectors move with the economy; defensive sectors are steadier through it.
Porter's generic strategies: cost leadership and differentiation.
A strategy is sound only if it can earn returns above the cost of capital over time.

Common mistakes

Treating NAICS as a commercial investment classification Fix: Link NAICS and ISIC to government statistics, and GICS and ICB to investors.
Assuming a company is classified by every product it sells Fix: Commercial systems assign one classification based on principal business activity, mainly the largest revenue source.
Treating shake-out and decline as the same stage. Fix: Shake-out follows rapid growth when growth slows and capacity is excessive. Decline is when demand itself is falling.
Assuming growth-stage industries always have the highest profits. Fix: Competition is rising in growth, and profits often peak later or are squeezed. Match the question's profit clues, not assumptions.
Confusing threat of substitutes with threat of new entrants. Fix: Entrants sell the same type of product. Substitutes sell a different product that meets the same need, such as video calls replacing business travel.
Assuming high barriers to entry also reduce rivalry among existing firms. Fix: High entry barriers mainly reduce the threat of new entrants; they do not by themselves reduce rivalry among existing firms. High exit barriers can intensify rivalry because weak firms stay and keep competing.
Confusing oligopoly with monopolistic competition. Fix: Count the firms. Many firms with low barriers is monopolistic competition. A few firms that react to each other is oligopoly.
Adding market shares instead of squaring them for HHI. Fix: HHI squares each share first, then sums. CRN simply sums the top shares.
Treating growth and cyclical as opposites. Fix: Growth describes long-run expansion from structural change. Cyclical describes sensitivity to the business cycle. An industry can be both.
Calling an industry defensive because it is large or stable in size. Fix: Judge by what happens to demand when income falls, not by how big the industry is.

Exam tips

Match the system to its purpose first. Most conceptual items turn on commercial versus government.
Remember that commercial systems assign one classification per company based on principal business activity.
Be wary of options that say classification guarantees comparability. The better answer says it is a starting point.
Know the level order for GICS (sector first) and ICB (industry first).
With three options, eliminate the two that confuse system types or ignore cyclicality and business mix.
Questions are usually clue-matching. Find the growth, pricing and competitor clues before looking at the options.
Eliminate options that contradict any one clear clue, such as falling prices in an embryonic industry.
Watch the shake-out versus decline pair. Look at whether demand is falling or just growth is slowing.