Overview
In theory, all industries exhibit a life cycle characterized by four stages: emerging growth, growth, maturity, and decline. However, the length of each stage varies from industry to industry and from company to company.
Did You Know?
The entire railway industry life cycle in Canada, from its beginnings to its present state of decline, is more than 150 years. In contrast, some high-technology industries have gone through a complete life cycle in just a few years.
Determining where an industry is in its life cycle is an important factor in the valuation process. Throughout that life cycle, sales volume at a company in the industry grows or declines. Therefore, each stage in the cycle affects the relationship between the firm’s pricing strategies and its unit cost structure.
Stages of Industry Life Cycle
Emerging Growth Industries
New industries continually develop to provide products and services that meet society’s changing needs and demands. These industries are known as emerging growth industries. Today, rapid innovation is particularly evident in software and hardware development in the computer industry.
Financial Characteristics
Emerging growth industries, and companies within them, tend to share certain financial characteristics:
- Initial Unprofitability: Typically, they are unprofitable at first, although future prospects may be promising.
- Negative Cash Flows: Large start-up investments may lead to negative cash flows.
- Survival Uncertainty: It is sometimes impossible to predict which companies will ultimately survive in a new industry.
Growth Industries
A growth industry is one in which sales and earnings are consistently expanding at a faster rate than in most other industries. Companies in these industries are called growth companies, and their common shares are called growth stocks.
Characteristics of Growth Companies
- Above-Average Earnings: A growth company should have an above-average rate of earnings on invested capital over several years.
- Increasing Sales and Units: Increasing sales in both dollars and units, with firm control of costs.
- Lower Cost of Production: During growth, costs of production reduce due to economies of scale.
Financial Implications
- Dividend Policies: Growth companies generally do not pay out large dividends because their growth is often financed through retained earnings.
- Valuation Metrics: They tend to exhibit high price-to-earnings (P/E) ratios and low dividend yields.
Mature Industries
Mature industries usually experience slower, more stable growth in sales and earnings that more closely match the overall rate of economic growth. Both earnings and cash flow tend to be positive. Within the same industry, it is more difficult to identify differences in products between companies leading to increased price competition and falling profit margins.
During recessions, stable growth companies usually demonstrate a decline in earnings that is less than that of the average company. These companies typically have sufficient financial resources to weather difficult economic conditions.
Declining Industries
As industries move from the mature/stable to the declining stage, they tend to stop growing and begin to decline. Declining industries produce products for which demand has decreased due to changes in technology, inability to compete on price, or shifts in consumer tastes.
Decline Characteristics
- Product Demand Drop: Decreased demand for products.
- Large Cash Flows but Low Profits: There’s no need to invest in new plant and equipment, leading to large cash flows but often low profits.
Key Takeaways
- Life Cycle Stages: Industries progress through different life cycle stages: emerging growth, growth, maturity, and decline.
- Financial Indicators: Each stage is characterized by unique financial indicators and performance metrics.
- Investment Implications: Understanding the life cycle stage is crucial for valuation and investment strategies.
Frequently Asked Questions (FAQs)
Q1: How do emerging industries impact investment decisions?
A1: Emerging industries might be unprofitable initially, involve large start-up costs and negative cash flows; cautious and well-informed investment decisions are required due to high uncertainty.
Q2: What are growth stocks?
A2: Growth stocks are shares of companies within growth industries, characterized by above-average earnings on invested capital and high market valuation ratios.
Q3: What is the defining trait of a mature industry?
A3: Mature industries attain slower but stable growth rates, featuring positive earnings, widespread consumer recognition, and increased price competition.
Q4: Why do declining industries still show large cash flows?
A4: Declining industries demonstrate large cash flows as they cease investing in new plant and equipment, though profit margins remain low due to reduced consumer demand.
Glossary and Definitions
- Life Cycle: The period through which every industry progresses including stages such as emerging, growth, maturity, and decline.
- Cash Flow: The total amount of money being transferred in and out of a business.
- Earnings on Invested Capital: A measure of a company’s profitability, calculated as net income divided by invested capital.
- Price-to-Earnings (P/E) Ratio: A valuation ratio of a company’s current share price compared to its per-share earnings.
Charts and Diagrams
gantt
dateFormat YYYY-MM-DD
title Industry Life Cycle Stages
section Life Cycle
Emerging Growth :a1, 2023-01-01, 6m
Growth :a2, after a1, 2y
Maturity :a3, after a2, 3y
Decline :a4, after a3, 1y
📚✨ Quiz Time! ✨📚
## What are the four stages in the industry life cycle?
- [ ] Growth, Maturity, Saturation, Decline
- [x] Emerging growth, Growth, Maturity, Decline
- [ ] Introduction, Expansion, Peak, Contraction
- [ ] Startup, Growth, Stabilization, Dissolution
> **Explanation:** The four stages in the industry life cycle are emerging growth, growth, maturity, and decline. This classification helps in evaluating the industry's and company's performance.
## Which industry characteristic is particular to the emerging growth stage?
- [x] Companies tend to be unprofitable at first with promising future prospects
- [ ] Companies consistently expand sales and earnings at a faster rate
- [ ] Companies experience slower, more stable growth in sales and earnings
- [ ] Companies produce products with declining demand
> **Explanation:** Emerging growth industries typically have companies that are unprofitable initially but have promising future prospects and might show negative cash flows due to large start-up investments.
## Growth industries often exhibit which of the following characteristics?
- [ ] Large dividends paid out to shareholders
- [x] High price-to-earnings ratios and low dividend yields
- [ ] Earnings and cash flow tend to be consistently negative
- [ ] Companies exhibit slow and stable growth in line with economic growth
> **Explanation:** Growth industries generally involve companies that maintain above-average growth and typically reinvest earnings into the business rather than paying out large dividends. This results in high P/E ratios and low dividend yields.
## How do mature industries typically behave during recessions?
- [ ] Their earnings and cash flow turn consistently negative
- [ ] They generally do not exhibit any decline in earnings
- [x] Their decline in earnings is less than that of the average company
- [ ] They become emerging growth companies once again
> **Explanation:** Mature companies generally have enough financial resources to weather difficult economic conditions, leading to a decline in earnings that is less significant compared to the average company.
## Which characteristic is commonly associated with declining industries?
- [ ] Positive cash flow due to high investments in new plant and equipment
- [x] Products with decreased demand due to changes in technology or consumer tastes
- [ ] Rapid sales growth rate and high demand for products
- [ ] Increasing competition with high profit margins
> **Explanation:** Declining industries produce products for which demand has declined, often because of changes in technology or consumer preferences, resulting in low profits despite potentially high cash flows.
## What happens to competition and profit margins in mature industries?
- [ ] Competition decreases, and profit margins increase
- [ ] Competition remains stable, and profit margins are unpredictable
- [x] Competition increases, and profit margins usually fall
- [ ] Competition and profit margins remain the same as in the growth stage
> **Explanation:** In mature industries, it becomes difficult to differentiate between products from different companies, leading to increased competition and falling profit margins.
## Why might growth companies exhibit high price-to-earnings ratios?
- [ ] Because they have unstable earnings and cash flows
- [ ] Because they pay out large dividends
- [x] Because they reinvest earnings instead of paying out large dividends
- [ ] Because they show inconsistent sales growth
> **Explanation:** Growth companies often reinvest their earnings to finance further growth, leading to high price-to-earnings ratios and low dividend yields as they do not pay out large dividends.
## What is one key characteristic of industries in the emerging growth stage?
- [ ] Companies have clear and stable cash flows
- [x] Large start-up investments tend to lead to negative cash flows initially
- [ ] Consistent earnings with slow growth rates
- [ ] Mature production technologies with declining competition
> **Explanation:** Emerging growth industries often require large initial investments, which can result in negative cash flows in the early stages despite promising future prospects.
## What indicates that a company belongs to a growth industry?
- [ ] Its sales and earnings are declining in line with general economic downturns
- [x] Its sales and earnings are consistently expanding at a faster rate than most other industries
- [ ] It mainly relies on dividends to attract investors
- [ ] It generates high cash flows with minimal investment in capital
> **Explanation:** Growth companies consistently expand their sales and earnings at a rate faster than most other industries, indicating their placement in the growth stage of the life cycle.
## Which factors can lead to the decline of an industry?
- [ ] Increased innovation in their products
- [ ] Consistent growth in profit margins
- [x] Changes in technology and consumer tastes reducing demand
- [ ] Low initial start-up costs and small investments
> **Explanation:** Decline in an industry can occur due to changes in technology and consumer tastes, which reduce the demand for the industry's products leading it to the decline stage.