Industry Life Cycle Analysis

What is Industry Life Cycle Analysis?

Industry life cycle analysis is part of fundamental analysis of a company involving the examination of the stage an industry is in at a given point in time. There are four stages in an industry life cycle: expansion, peak, contraction, trough. An analyst will determine where a company sits in the cycle and use this information to project future financial performance and estimate forward valuations (e.g., forward price-earnings ratios).

Understanding Industry Life Cycle Analysis

Though not necessarily the case, the life cycle of a particular industry will follow the general economic cycle. Moreover, an industry life cycle may lead or lag an economic cycle, and can vary from an economic cycle's phases in terms of expansion or contraction percentages or duration of peak and trough stages. During an expansion phase in open and competitive markets, an industry will experience revenue and profit growth, drawing in more competitors to meet the growing demand for that industry's goods or services. The peak occurs when growth drops to zero; demand in the cycle has been met and prevailing economic conditions do not encourage additional purchases. Industry profits flatten out.

The contraction phase of the life cycle begins at some point after the peak arrives, characterized by falling profits as current period sales are lower relative to prior period sales (when demand was on the rise). The contraction phase could be concomitant with a recession in the economy or merely a reflection that short-term demand in the industry has been exhausted. During the contraction phase, the industry undergoes production capacity adjustments, whereby marginal players get shaken out and stronger companies lower their production volumes. Industry profits decrease.

This adjustment process, combined with a firming of the economy observed in employment and personal income numbers and the consumer confidence index, lead to the trough phase of the industry life cycle. At this stage, lower levels of industry demand are matched by the output capacity. As the economy gathers strength, the industry life cycle begins again with the expansion phase. As mentioned at the outset, an industry life cycle is typically tied to the economic cycle. The entertainment and leisure industry is an example of such an industry. The technology industry, on the other hand, has exhibited life cycle movements at variance with the economic cycle. For instance, industry profits have boomed even in times of no economic growth.

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Using Industry Life Cycle in Analysis

Analysts and traders often use industry life cycle analysis to measure the relative strength and weakness of a particular company's stock. A company's future growth prospects may be bright (or dim) depending on the stage that it is in during an industry life cycle. Porter's five economic forces change as an industry matures. For example, rivalry is most intense between companies in a sector during the growth stage. Startups slash prices and ship product as quickly as possible in a bid to garner as many customers as possible. During this time, the threat of new entrants eating into an existing company's market share is high. The scenario changes in the maturity stage. Less competitive startups and inferior products are weeded out or acquired. The risk of new entrants is low and the industry's product is mature enough to be accepted in mainstream society. Startups become established firms during this stage but their future growth prospects are limited in existing markets. They must search out new avenues and markets for profits or risk extinction.

Example of Industry Life Cycle Analysis

There was a boom in social media during the early 2000s due to the success of Myspace, a social networking site that surpassed Google as the most visited place on the Internet in 2006. Sites like Orkut (a Google venture) and Bebo competed to gain users in a crowded landscape. Facebook, which had started in 2004, was also fast gaining traction among universities and was considered the second most popular social media site. There were signs of consolidation when Myspace was acquired by Rupert Murdoch's Newscorp. Ltd for $580 million in 2005.

But that valuation turned out to be inflated after Facebook overtook MySpace in rankings. MySpace eventually petered into insignificance after Facebook became a social media behemoth. With the exception of a few, like Twitter, other social media sites also fell by the wayside. The social media sites that survived made a thumping debut on the stock market. Their valuations were considered high in comparison to their revenues, mainly because investors expected significant growth in the future as social media became popular throughout the world.