Investment & Financial Articles
Title: Porter's Five Forces Analysis
Author: Chris Mallon
Article:
This article looks at an analysis tool called the Porter's Five
Forces Analysis. In his book Competitive Strategy, Harvard
professor Michael Porter describes five forces affecting the
profitability of companies. These are the five forces he noted:
1) Intensity of rivalry amongst existing competitors 2) Threat
of entry by new competitors
3) Pressure from substitute products
4) Bargaining power of buyers (customers)
5) Bargaining power of
suppliers
These five forces, taken together,give us insight
into a company's competitive position, and its profitability.
Rivals
Rivals are competitors within an industry. Rivalry in the
industry can be weak, with few competitors that don't compete
very aggressively. Or it can be intense, with many competitors
fighting in a cut-throat environment. Factors affecting the
intensity of rivalry are:
Number of firms - more firms will
lead to increased competition.
Fixed costs - with high fixed
costs as a percentage of total cost,
companies must sell more products to cover those costs,
increasing market competition.
Product differentiation - Products that are relatively the same
will compete based on price. Brand identification can reduce
rivalry.
New Entrants
One of the defining characteristics of
competitive advantage is the industry's barrier to entry.
Industries with high barriers to entry are usually too expensive
for new firms to enter. Industries with low barriers to entry,
are relatively cheap for new firms to enter. The threat of new
entrants rises as the barrier to entry is reduced in a
marketplace. As more firms enter a market, you will see rivalry
increase, and profitability will fall (theoretically) to the
point where there is no incentive for new firms to enter the
industry. Here are some common barriers to entry:
Patents -
patented technology can be a huge barrier preventing other firms
from joining the market.
High cost of entry -
the more it will
cost to get started in an industry, the higher the barrier to
entry.
Brand loyalty -
when brand loyalty is strong within an
industry, it can be difficult and
expensive to enter the market with a new product.
Substitute Products -
This is probably the most overlooked, and
therefore most damaging, element of strategic decision making.
It's imperative that business owners (us) not only look at what
the company's direct competitors are doing, but what other types
of products people could buy instead. When switching costs (the
costs a customer incurs to switch to a new product) are low the
threat of substitutes is high. As is the case when dealing with
new entrants, companies may aggressively price their products to
keep people from switching. When the threat of substitutes is
high, profit margins will tend to be low.
Buyer Power
There are
two types of buyer power. The first is related to the customer's
price sensitivity. If each brand of a product is similar to all
the others, then the buyer will base the purchase decision
mainly on price. This will increase the competitive rivalry,
resulting in lower prices, and lower profitability. The other
type of buyer power relates to negotiating power. Larger buyers
tend to have more leverage with the firm, and can negotiate
lower prices. When there are many small buyers of a product, all
other things remaining equal, the company supplying the product
will have higher prices and higher margins. Conversely, if a
company sells to a few large buyers, those buyers will have
significant leverage to negotiate better pricing. Some factors
affecting buyer power are:
Size of buyer -
larger buyers will
have more power over suppliers.
Number of buyers -
when there
are a small number of buyers, they will tend to have more power
over suppliers. The Department of Defense is an example of a
single buyer with a lot of power over suppliers.
Purchase
quantity -
When a customer purchases a large quantity of a
suppliers output, it will exercise more power over the supplier.
Supplier Power Buyer power looks at the relative power a
company's customers has over it. When multiple suppliers are
producing a commoditized product, the company will make its
purchase decision based mainly on price, which tends to lower
costs. On the other hand, if a single supplier is producing
something the company has to have, the company will have little
leverage to negotiate a better price. Size plays a factor here
as well. If the company is much larger than its suppliers, and
purchases in large quantities, then the supplier will have very
little power to negotiate. Using Wal-Mart as an example, we find
that suppliers have no power because Wal-Mart purchases in such
large quantities. A few factors that determine supplier power
include:
Supplier concentration -
The fewer the number of
suppliers for a given product, the more power they will have
over the company.
Switching costs -
suppliers become more
powerful as the cost to change to another supplier increases.
Uniqueness of product -
suppliers that produce products
specifically for a company will have more power than commodity
suppliers. It's important to analyze these five forces and their
affect on companies we want to invest in. The Porter Five Forces
Analysis will give you a good explanation for the profitability
of an industry, and the firms within it. If you want to know why
a company is able, or unable, to make a decent profit, this is
the first analysis you should do.
About the author:
Chris Mallon is the editor and publisher of the Undervalued
Weekly, a financial analysis newsletter. Chris holds a Master of
Science in Finance and is the leading analyst for the Dynamic
Investors partnership. He is available at
chrismallon@dynamicinvestors.net or the through the website at
www.dynamicinvestors.net/index5.html
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