Michael Porters’ Five Forces Examined

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The investment process would be incomplete without a proper understanding of the dynamics of the industry in which a company competes. Though this type of analysis can be aided by quantitative measures, it does not lend itself to the clear structure of spreadsheet modeling, and it has a nebulous nature that often leaves investors wondering if they’ve done it right and covered all the bases.

In the 1970s Dr. Michael Porter of Harvard Business School recognized the lack of rigour in then-current analytical frameworks and set out to develop a new, comprehensive framework that would capture both internal and external threats as well as both horizontal and vertical competition. The result has come to be known as a Porter’s Five Forces analysis, as Porter had distilled the key elements into five parts, the analysis of which would allow a person to assess the attractiveness of an industry.

Michael Porters' Five Forces Examined

Threat of New Entrants: As new entrants begin to compete in the industry, existing firms will find their profitability erode. This continues until industry-wide profitability normalizes and the industry becomes less attractive for new entrants. Investors should be on the lookout for barriers to entry that preserve incumbent market share and profitability. Here are some key things to consider:

  • Are there high economies of scale that would prevent profitability for all but the highest volume producers?
  • Do incumbents compete on a metric that is difficult to reproduce? (e.g. reputation for excellence)
  • Do incumbents utilize distribution channels that challengers would be unable to reproduce?
  • Are there legal barriers to entry? (e.g. intellectual property, regulatory, etc)
  • Are there high switching costs for existing customers that would make it difficult for new entrants to capture market share? Even if switching costs are low, do the potential benefits of switching (cost savings, etc) justify the possible consequences of switching? (unproven relationship, possible quality concerns, etc)
  • Are there high capital requirements? (note that this is perhaps the least defensible in this list, as there will almost always be capital available for above-normal returns).
  • How easily can the company’s products be compared to those provided by other firms?

Threat of Substitutes: Competitors can be other firms selling the same or very similar products/services, or alternative products/services that fill the same need for the customer. For example, short-haul airlines compete both with each other on select routes as well as alternative modes of transportation (driving, bus, train). Similar to the threat of new entrants above, the ease in which customers can switch to alternatives affects the ability of industry participants to increase prices and earn above-normal returns. Here are some key things to consider:

  • What are the key differentiating factors between substitute products and the company’s products in the customer’s mind, and how do these rank in importance? (e.g. purely price-driven, or is there greater consideration for reliability, convenience, safety, etc?) How does the industry’s products stack up on these metrics?
  • How easily can the company’s products be compared to those provided by other firms (including substitute products)?
  • Are there high switching costs for existing customers? Even if switching costs are low, do the potential benefits of switching (cost savings, etc) justify the possible consequences of switching? (unproven relationship, possible quality concerns, etc)
  • Are the industry’s products bundled with other essential products that customers need? (e.g. title insurance)

Bargaining Power of Customers: It is in the customer’s interest to pay the lowest possible price, and the company’s interest to charge the highest possible price. These competing interests collide in the (often implicit) bargain that occurs during the sale, and the degree of bargaining power possessed by each party determines whether the company is able to earn above-normal returns. Here are some key things to consider:

  • How concentrated are the company’s sales to its largest customers? If the top few customers account for a disproportionate share of the company’s sales, then the company will be less capable and less willing to jeopardize those sales by charging prices that reflect above-normal returns. Large customers are able to demand price concessions due to volume, as well as special (and costly) services that smaller customers would be unable to procure.
  • Consider the operating leverage (the degree of fixed costs in the company’s operating strategy) of the company and the industry. Where there exists significant fixed costs, customers are able to use this fact to their advantage in that each marginal sale contributes a disproportionate amount of profit to the company through economies of scale.
  • Do customers face high switching costs? The greater the extent to which customers are “captured” or unable to switch, the less bargaining power they possess.
  • How easily can the company’s products be compared to those provided by other firms (including substitute products)?
  • Are substitute products available?
  • Are customers highly price sensitive?
  • Do customers possess the ability to backward integrate if prices (and profitability) increase too much?

Bargaining Power of Suppliers: Suppliers to the industry wish to capture as much of the profit in the value chain as possible. If an intermediary is earning excessive profits, suppliers will raise prices in order to capture a greater share of the profit. Here are some key things to consider:

  • How are inputs differentiated? Commodity products among competing suppliers eliminates supplier bargaining power as the price is set by market forces.
  • Are substitute products available that the firm could switch to if the supplier raises prices?
  • Are there switching costs?
  • Does the firm compete with its supplier? (Is there a threat of forward integration?)

Competitive Rivalry: The intensity in which industry participants compete is both a factor of the above mentioned points as well as an independent consideration. In industries where there are few reasonable substitutes, high barriers to entry and low bargaining power among both customers and suppliers, there should be less pressure for incumbent firms to compete, but nonetheless sometimes participants exert unnecessary pressure that erode industry profits. Here are some key things to consider:

  • How concentrated is the industry? As concentration increases, competition tends to decrease.
  • Is this a fast growing industry?
  • Are there barriers to exiting the industry which could lead to desperate behaviour?

You can read Porter’s original 1979 paper on the five forces, How Competitive Forces Shape Strategy [PDF] and another paper, The Five Competitive Forces that Shape Strategy [PDF]. Also, you might be interested in watching this interview with Michael Porter discussing the five forces:

What would you add to this discussion of the five forces? What has been your experience applying this in your investment process?