Industry Analysis using Porter’s Five Forces Model

Frameworks

There are a number of different frameworks available for business analysis. One of the most recognized of these frameworks is called Porter’s Five Forces and is used to analyze the five forces that determine the competitiveness and attractiveness of a particular industry, to identify the major players in the industry, and to summarize the interaction amongst all the players.

The framework is named after Michael E. Porter, a professor at Harvard University whose core field is corporate strategy. He is considered by many to be the father of corporate strategy due to his early and insightful work on the subject.

Porter’s five forces is not a blanket solution for understanding a company’s place in its industry, and it does not necessarily require in-depth quantitative analysis. That being said, the more detailed the analysis, the higher the benefit you will obtain from a deep understanding of an industry. It is however, a simple but powerful framework, which if applied correctly, can help you identify opportunities and threats within an industry.

When to Use It

The model can be used by corporate insiders to evaluate whether to pursue new opportunities in a different industry or evaluate their competitive position within the industry they currently operate in. But the framework can also be a useful tool for investors evaluating the attractiveness of investing in a particular company’s stock and to identify the opportunities and risks the company will face in its industry or new endeavors it decides to pursue.

For our purposes, we will outline the framework from the perspective of a potential investor into the company’s stock.

There are two basic approaches to equity investing: bottom-up and top-down. Bottom up investing typically entails a quantitative screen that identifies companies meeting certain criteria, such as a return on equity above 15%, or revenue growth of at least 20%, or a price/earnings multiple less than 10. Once a list of these stocks are identified, the analysis focuses on the specific situation of the company, including its financial stability, market strategy, valuation, etc. While a macro or industry analysis will still be relevant, investors that use a bottom up approach may in fact invest in industries with poor prospects, if they feel that a particular company will still perform well.

On the other hand, there is a top-down approach, which starts with a macro economic analysis to identify industries poised to perform well in the current environment. Once these industries are identified, individual companies are analyzed to determine the best positioned company to outperform within those industries.

It’s no surprise then that the top-down money managers will probably be more likely to use Porter’s Five Forces model to evaluate investment opportunities. But that doesn’t mean that the bottom up investor cannot benefit from the use of Porters to further evaluate the future performance of a company. It would still behoove an investor to understand the industry dynamics of a company before investing. For example, a company may have the highest margins in its industry and be positioned as a powerful member of the value-chain, with pricing power and a distinct product that is difficult to duplicate at the same price. A Porter’s Five Forces analysis may identify the threat of a new entrant into the industry, or the growing influence of a supplier that may begin to affect the company’s future profit margins.

The point I am trying to make here is that the Porter’s Five Forces model has an applicable use regardless of the investment approach.

The Porter’s Five Forces Model

The Porter’s five forces model can be depicted quite simply with the diagram below:

Porters-Five-Forces

 

 

 

 

 

 

 

 

 

What determines the effectiveness of applying the model is the level of detail applied to uncovering the information relevant to each of the five forces described above. While the diagram may seem simple, the following few paragraphs attempt to provide additional insight into the application and use of the framework.

Competitive Rivalry

The intensity and form of competitive rivalry can have a huge impact on the dynamics within an industry. Not unlike sports, rivalries can be friendly and competitive or hostile and unproductive. Rivalry among industry players can affect profits and make certain industries less attractive for both current industry participants and potential new entrants. Or, it could inspire innovation and product improvements that spur profits for all industry participants and hence, new entrants.

Some of the factors that impact the competitive rivalry of an industry are the number of firms in the industry, the level of fixed costs, and the level of exit barriers. The larger the number of firms competing in an industry, the more likely there will be intense competition for the same customers. The same could be said for industries where fixed costs are high and or exit barriers are costly. In industries with high fixed costs, for example, it would be too costly to ‘give up’ after having set up manufacturing plants, or invested in research and development. When fixed costs are high, companies tend to ‘stay and fight’ to try to recover those costs. The same is true within industries with high exit barriers. If exiting an industry requires a company to spend additional capital or accept large losses, it too will prefer to stay in an industry and compete.

Situations where this applies can result in a very competitive environment that may include cost-cutting, increased marketing expenses, and higher and more frequent research and development expenses geared towards product innovation.

Rivalries can also be intense if there are multiple companies operating with the same business strategy, for example, when there are multiple low cost providers or several companies in an industry offering premium products. In the auto industry, for example, Kia and Hyundai had been known to be the lower cost providers compared to brands like Audi, BMW, and Mercedes Benz. The competition until recently was among Audi, BMW, and Mercedes, for the premium brand, while Kia and Hyundai were competing for a different consumer. Now that both Kia and Hyundai are producing ‘luxury’ cars, the rivalry may intensify across all auto manufacturers.

It is also important to determine how easily a customer can switch from one product/service to another. The lower the switching cost for a customer, the more intense will be the rivalry to keep current customers while the competition tries to steal them away. Higher switching costs, however, doesn’t translate into a less intense rivalry. In situations where switching costs are high, the rivalry may be extremely intense during the customer acquisition phase, since each company knows that once a customer becomes a customer, they will be unlikely to switch.

I also mentioned that some rivalries may be friendlier than others. A good example is the rivalry among oil and gas distributors, or more specifically, gas stations. Quite often they sit right across the street from each other at major intersections. An intense competition may hurt all players if one company reduces the price of gas to try to attract more customers. The other company must then lower its price as well to compete at the lower price, setting in motion a price-cutting spiral that hurts everyone.

Threat of new entrants

Profitable markets will attract new firms. An industry with high profit margins can be expected to attract many new entrants. It may not occur quickly, but if profits stay high, other companies will want a piece of the pie. This results in an influx of new entrants, which eventually will decrease profitability for all firms in the industry. Unless the entry of new firms can be prevented, the unusually high profit margins decline to a level considered equilibrium.

The existence of barriers to entry can be a deterrent for outsiders Barriers to entry may include: patents, capital expenditures, product expertise, technological capabilities, economies of scale, to name a few. The most attractive industry therefore, is one in which entry barriers are high and exit barriers are low. Needless to say, there aren’t many industries that fit that description. In the long-run, there are no barriers to entry or exit. In the long-run, patents expire, capital expenditures result in facilities and resources, product expertise can be developed or acquired, technological capabilities can be copied, and economies of scale can be duplicated or made obsolete. For example, the large footprint of a Kmart or Sears or any other retailer has been challenged by the online capabilities of Amazon. An important question to ask is ‘how long can high barriers to entry last?”

Bargaining power of customers (buyers)

The bargaining power of customers can best be described as the terms that customers can demand of companies because of the old ‘you need me more than I need you’ concept. For example, Apple is a very powerful customer compared to its suppliers. Apple has the option to switch it’s supplier of plastic or semiconductors, or glass in a relatively short period of time. And it’s highly likely that Apple is many a supplier’s largest customer.

In general, the higher the number of customers a company has, the less bargaining power each customer will have. For example, a company with a majority of sales to one large customer will oftentimes have to provide that customer with favorable terms, as in the case of Apple or Wal-Mart, who is also known to drive a hard bargain with its suppliers. If costs of switching are high, then the bargaining power of that relationship may be more evenly split and this type of relationship may even result in a stronger partnership. However, if costs of switching are low, then the customer can demand more attractive terms or threaten to buy from someone else. That is why the more customers a company has, the less likely that power will lie within the customers.

Another factor in determining the level of bargaining power of a customer is the size and frequency of orders placed by that customer. A customer placing one small order will have less bargaining power than a company placing many small orders over a longer period of time. In general, ask yourself, who needs who more? And that should lead you in the right direction.

Bargaining power of suppliers

The bargaining power of suppliers is determined by the uniqueness of suppliers products or services as well as a company’s ability to switch suppliers. Suppliers of raw materials, for example, with very little differentiation among the quality of material, will have less power than a supplier with an inordinately higher quality of product that is difficult to substitute. And it is important to understand not only the suppliers capabilities but how it satisfies the need of the customer. In the case I just mentioned, a higher quality product may be too expensive for a customer, which leaves the opportunity available to the lower quality, low cost producers. It’s important to evaluate supplier capabilities within the context of what customers demand. I can produce the best quality eyeglasses in the world, but it wouldn’t give me any leverage if my customers were blind. It is also important to note the number of suppliers in the industry even if they are not currently servicing the company being analyzed. The fact there could be a high number of suppliers means the company can potentially switch if the need arises. On the other hand, if there exists only one supplier of a particular input needed for a company’s products, it would be difficult, costly, and/or impossible to switch.

Threat of substitute products or services

An often overlooked factor in evaluation of companies and industries is the threat of substitute products. These aren’t the same products offered by other companies, but rather, different products that satisfy the same need as the product being offered by the company being analyzed.

Some examples of substitute products are below:

  • Bottled water as a substitute for Pepsi Cola in order to quench thirst – this trend is already under way as evidenced by recent reports that soda consumption is down considerably in the developed world.
  • Tablets as a substitute for computers to surf the internet
  • Smart phones as a substitute for landlines to communicate
  • Pens instead of pencils to write
  • Cars instead of horses to travel

The cost of changing products is a key factor and when the cost is negligible and the perceived level of differentiation is low, the substitution risk is high.

Qualitative not Quantitative

You may have noticed by now that the Porter’s Five Forces Model is very qualitative in nature. It does incorporate some quantitative factors, such as switching costs, capex requirements, and a few others, but for the most part, it is a very subjective approach. Each one of us will have our own opinions about the dynamics of an industry and beyond quantitative facts, it would be difficult to argue one way or another. You may consider a company to have a high level of bargaining power over another, while someone else may think it’s just the opposite. Each of our own experiences will have an impact on the end result of the analysis. For example, bottled water has been a viable substitute for Coke and Pepsi as the U.S. consumer has become more health conscious and focused on reducing obesity. But we could argue all day on whether water is a viable substitute for Coke for a 13 year old boy. Opinions on that may vary considerably.

Most analysts use the same concepts presented by the model in some way or another. The model simply provides a framework to structure the analysis around the 5 forces mentioned. As an individual investor, you may want to keep the model in mind when evaluating a company for your personal portfolio even if you don’t apply the model exactly as it’s described here. By asking yourself the same questions that are outlined in the model, you should be able to get a good understanding of how the company is positioned and whether there are inherent risks you should be aware of.

One last note on Conglomerates

There are many companies that have grown both organically and through acquisitions and now operate in more than several unrelated industries. It would be impossible to apply a Porter’s Five Forces model to analyze that company and gain any meaningful insight. The more prudent approach is to apply the Porters model separately to each industry the company operates in. This is the only way to properly gauge the company’s position within each industry. You may discover that it is very well positioned in one industry but not in others. The question then becomes, which is the more profitable industry going forward?

I hope this article serves you well in your analysis for future stock investments. As always, if you have any comments, suggestions, or questions, please do not hesitate to contact me. To order Michael Porter’s book, Competitive Strategy: Techniques for Analyzing Industries and Competitors.