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 to an industry?
- Its principal source of revenue — correct
- Its market capitalisationWhy not: Size determines whether a company appears in a large or small capitalisation index, not what business it is judged to be in.
- Its country of incorporationWhy not: That drives geographic classification. A company can be incorporated in one country and earn everything in another industry entirely.
The main business activity determines the assignment, which is objective and reproducible but can misplace diversified or transitioning companies.
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 peers are defined by demand drivers — correct
- Because classifications exclude non-domestic companiesWhy not: Major schemes are global and cover companies wherever they are listed.
The companies facing the same demand drivers may sit in different classified sectors. A payments company classified as technology may compete with banks classified as financials, and comparing multiples within the assigned sector then compares unlike businesses.
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
It says nothing about the structure of competition within an industry. Two companies can be equally cyclical and face entirely different competitive conditions, so the classification answers a macro question, not a micro one.
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 →