The concentration ratio indicates the size of organizations in relation to their industry as a whole. Concentration ratio is the total market output produced by the n largest firms in an industry, expressed as a percentage. Market output may be defined by market capitalization, sales volume, or any other metric describing the dominance of a company relative to its competitors.
Concentration ratio is used as a measure of market monopolization. That is, whether an industry is comprised of many smaller firms or a few, larger firms. Markets characterized by the former tend to be more competitive with concentration ratios under 50%. Conversely, markets characterized by the latter tend to be less competitive with concentration ratios over 50%. In cases where a single firm dominates its industry, the concentration ratio may be near 100%.
The four-firm concentration ratio is a commonly used ratio that considers the market share of the four largest firms in an industry. An similar approach is also used in three, five, and eight-firm models.
Interpreting concentration ratio percentages
Concentration ratio percentages can yield important insights into market competitiveness, including:
The degree of competition – if concentration ratios under the five-firm model rise from 40% to 60%, this may be an indication of lower competitive pressure and higher prices for consumers.
Monopolies – concentration ratio percentages also identify companies likely to operate a monopoly in their respective market. In some cases, the approach can also identify the companies likely to hold a monopoly in the future.
Regulatory oversight – a value of 80% or more under the three-firm model means there is greater scope for collusion between each firm. These markets are characterized by oligopolies, where a small number of firms work to restrict output and/or fix prices to achieve superior market returns. For this reason, many governments have regulatory bodies in place for vulnerable industries such as gas, electricity, oil, and air transportation.
Limitations of concentration ratios
Concentration ratios can provide inaccurate results due to the scope the market evaluated, particularly if local, national, and global markets are involved. For example, two organizations may dominate the local market while having little to no presence in the national market. Estimating market size is also highly subject in some cases. If regulatory bodies were trying to identify the size of the market Facebook operates in, would it incorporate phone apps, photo-sharing websites, or a mixture of both?
What’s more, there are situations where concentration ratios cannot quantify monopoly power. Consider the example of a national market where only one sugar company exists. Though the company may appear to have a monopoly at first glance, it is actually in direct competition with large food wholesalers who choose to import sugar alongside various other products. The wholesaler operates in a different sector but is nonetheless in direct competition with the sugar company that must then adjust its prices accordingly.
Key takeaways:
The concentration ratio indicates the size of organizations in relation to their industry as a whole. Markets comprised of more numerous smaller firms tend to have low concentration ratios, while markets comprised of a few larger firms tend to have high concentration ratios.
Concentration ratios yield important insights into market competitiveness, including the degree of competition and the presence of monopolies, oligopolies, and potential regulatory oversight.
The concentration ratio is not suited to situations where the scope of a market or the extent of monopoly power is difficult to define.
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
