Set out ways of assigning companies to industries
The idea
Companies are grouped by principal business activity, by sensitivity to the business cycle, or by statistical similarity of returns. Commercial schemes such as the global industry classification standard assign each company to one sector mainly on the basis of its main revenue source, which is reproducible but places diversified companies awkwardly and can lag a company's actual transformation. Cyclical and non-cyclical classification is more useful for asset allocation than for competitive analysis. The right peer group for valuation is the set of companies facing the same demand drivers, which no standard scheme reliably produces.
A practice question
On what basis do commercial classification schemes usually assign a company?
- Its principal source of revenue - correct
- Its market capitalisationWhy not: A size measure, used to sort companies within an industry rather than to decide which industry they are in.
- Its country of incorporationWhy not: A geographic attribute. Two companies incorporated in the same place may do entirely unrelated things.
Classification schemes sort companies into industries so analysts can compare similar firms. Commercial schemes place each company in one industry according to its main business, which in practice means its largest source of revenue. A firm earning 70% of its revenue from software would be classed as software, even if the other 30% comes from hardware. This is easy to repeat consistently but is a blunt tool. Market capitalisation (the total value of a company's shares) is a size measure, and country of incorporation is where the firm is legally based, so neither shows what the company does.
A harder one
Why is a standard classification sometimes a poor guide to the right valuation peer group?
- Because classifications are updated only every ten yearsWhy not: Providers review assignments regularly, often annually. The problem is what the rule captures, not how stale it is.
- Because companies with the same demand drivers can sit in different sectors - correct
- Because classifications exclude non-domestic companiesWhy not: Major schemes are global and cover companies wherever they are listed.
A good peer group is made of companies facing the same demand drivers, costs and risks. But a scheme assigns each company by its main source of revenue, so real competitors can land in different sectors. For example, a payments company classified as technology may compete with banks classified as financials, so comparing its multiples with other technology firms compares unlike businesses. Analysts treat the classification as a starting point, then check each peer's business. Updates are regular and the schemes are global, so staleness and coverage are not the problem.
The hardest tier
Why is cyclical versus non-cyclical classification more useful for asset allocation than for competitive analysis?
- Because cyclicality is easier to measure than market shareWhy not: Ease of measurement is not the issue; the two classifications answer different questions, and only one is about rivalry.
- Because non-cyclical companies have no competitorsWhy not: Food retailers and utilities compete fiercely. Stable demand says nothing about how the industry's profit is divided.
- Because it describes sensitivity to the economy - correct
A cyclical company's profits rise and fall strongly with the economy. A non-cyclical company's profits stay steadier. This label describes sensitivity to the economy, which matters when deciding how much of a portfolio to put in each type of business at different points in the economic cycle. It says nothing about competition inside an industry. Two firms can be equally cyclical and face very different rivals. So it answers a big-picture question, not a question about rivalry. Non-cyclical firms still compete, for example food retailers.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →