Herfindahl-Hirschman Index (HHI)

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What is Herfindahl-Hirschman Index (HHI)?

HHI is a score that helps to measure market concentration and used to determine market competitiveness. HHI is named after economists Orris C. Herfindahl and Albert O. Hirschman. It is an economic concept widely applied in competition and antitrust law. A highly concentration industry is the one where only a few players dominate the industry by holding a huge market share, leading to a near-monopolistic industry. Conversely, low degree of concentration refers to near-perfect competition scenario where many companies hold small market share.

 

Why is HHI important to an investor?

HHI helps to measure market concentration which in turns helps us to determine profitability is the industry. There is a direct relation between market concentration and profitability. Low concentration perfect market and in perfect market there is cut-throat competition. So, it is difficult for the firm to earn above average returns. High concentration indicates near-monopolistic market and monopolistic market helps the firm to earn above market return. As an investor, it is important for us to known profitability of the industry. So, we should check HHI of the industry before investing in the company.

 

HHI Calculation

HHI is calculated by squaring the market share of each competing firm and then summing the resulting numbers. HHI value can range from 0 to 10,000. The HHI can have a theoretical value ranging from close to zero to 10,000.  If there exists only a single market participant which has 100% of the market share the HHI would be 10,000.  If there were a great number of market participants with each company having a market share of almost 0% then the HHI could be close to zero.

Formula:


Example:

In the above question we can see that HHI of the industry is 2192. Does 2192 indicate high concentration or low concentration? Let us understand what each value of HHI mean.

 

Interpreting HHI value

HHI score is directly proportional to the concentration in a particular market. That means, a higher HHI value or score reflects a higher concentration in industry and thus reflects lesser competition. Similarly, a lower HHI score would entail the presence of good competition around firms in an industry. A value closer to 10,000 or 1 would indicate the presence of monopoly and a value closer to 0 would indicate healthy competition and almost null concentration among firms.


Value between 0 to 1500: It indicates that the industry has low concentration and a competitive industry.

Value between 1500 to 2500: It indicates that the industry is moderately concentrated and a healthy competition.

Value higher than 2500: It indicates that the industry is highly concentrated and is a near-monopolistic market.

The primary advantage of HHI is that it is simple and is less dependent on huge data sources.  Rather, it requires only a handful of data to calculate HHI index. But there are some limitations of HHI. Let us understand those.

 

Limitation of HHI

A major disadvantage of HHI is that it is simplistic in nature. Since, the formula is simple it fails to undertake various market adversaries and complexities that are present in today’s market structure. For example, a company may have small market share but may hold a dominant position in a particular geographical market. Also, limitation of defining a market persists in a scenario where intra-industry competition exists. An industry would look competitive, but each firm may hold dominant position in a particular market segment. For example, Asian paints is a dominant player in home decor paint while Nerolac is a dominant player in industrial paint segment.

 

To Wrap Up,

Despite its limitation, HHI is a good tool to assess market concentration. High HHI indicates high concentration industry with above average profits. Conversely, low HHI indicates low concentration and below average profits. As an investor, we should invest in companies which come under high concentration industry. Along with HHI, we should also perform PESTLE and Porter analysis and do our own exhaustive research to understand industry structure.

Happy Investing!

 

Disclaimer: Companies used as an example in this blog are for educational purposes and not an investing advice.

 

 

 

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