Determining which industries will earn economic profits (return on invested capital in excess of the cost of capital) is typically dependent on understanding the competitive environment within the industry. Strategic analysis is the analysis of the competitive environment with an emphasis on the implications of the environment for corporate strategy. Michael Porter’s “five forces” framework is the classic starting point for strategic analysis.
Porter’s Five Forces
Porter identified five determinants of competition intensity in an industry
- Threat of entry
- Power of suppliers
- Power of buyers
- Threat of substitutes
- Rivalry among existing competitors
Industry Life-Cycle Model
An industry’s life-cycle position often has a large impact on its competitive dynamics, making this position an important component of the strategic analysis of an industry. There are five stages in the industry life-cycle model, including the embryonic, growth, shakeout, mature, and decline stage. Each stage is characterized by different opportunities and threats.
Company ROIC WACC Company A 30% 32% Company B 8% 3% Company C 16% 13%
ROIC: Return on invested capital
WACC: Weighted average cost of capital
Which company is generating the most economic profit as a percentage of capital invested?
A. Company A
B. Company B
C. Company C
The correct answer is B.
Economic profit as a percentage of capital invested is essentially the difference between the return on capital and the cost of capital. Company A is earning negative economic profit (30% – 32% = -2%) despite having the highest return on invested capital. Company C has a higher return on invested capital than Company B, but is only earning three cents of economic profit (16% – 13%) for every dollar invested. Company B, however, is earning five cents of economic profit per dollar (8% – 3%).
Reading 48 LOS 48f:
Describe the principles of strategic analysis of an industry