Revenue Ruling 59-60, the Holy Grail of Business Valuations states that industry analysis is a factor that is fundamental and requires careful analysis in each case. The question becomes, where do you find information on how to analyze an industry.
Five Forces of the Industry
Michael Porter, Ph. D, discusses the five forces of the industry and how to analyze these forces. Dr. Porter’s analysis and publications have become the gold standard within the business valuation community for researching an industry.
The five forces are: (1) threat of new entrants, (2) bargaining power of suppliers, (3) bargaining power of buyers, (4) threat of substitute products and (5) rivalry among existing competitors. Each of these items should be analyzed and work papers retained to indicate that there is sufficient relevant data to indicate relevance and reliability of the industry research. The analysis provides a better understanding to the business valuation expert how the industry operates.
I will be presenting all five of these forces in a series or presentations so they are easier to digest and understand.
Threat of New Entrants
Some of the items to be considered in this analysis is; (1) can the new entrants enter this industry with ease, (2) is the industry expected to grow more slowly than the economy as a whole, (3) are risk-adjusted rates of return in this industry unlikely to attract new entrants, (4) does competing successfully in this industry require investment that crates high opportunity costs (industry specific equipment, processes or certificates)?
A high increase in new entrants could result in a reduction of revenues and may result in additional capital expenditures for an existing company in order to remain competitive with the new entrants.