Industry analysis using Porter’s five forces
Industry analysis has become a prerequisite for the investment process. Before arriving at any investment decision, investors should be aware of the business environment along with the competitive edge a company has in its industry. There are various methods for carrying out industry analysis; Porter’s five forces model is one of the most popular models used all around the world.
The five forces
Harvard Business School professor, Michael E Porter developed what we know as Porter’s five forces. It was published in his book ‘Competitive Strategy: Techniques for Analysing Industry & Competitors’ in 1980. He observed the five factors that are indispensable for industry analysis; rivalry amongst existing competitors, the threat of new entrants, the threat of substitutes, the power of buyers, and the power of suppliers. Let us have a look at each of the forces in brief.
Rivalry among the existing competitors
The larger the competition in the industry, the lesser is the pricing power a company has. Fewer players in the industry give some liberty to a company to charge higher prices and enjoy high margins as well as profitability.
Threat of new entrants
Imagine opening a restaurant chain or an e-commerce business, and now, imagine opening an automobile manufacturing company! Which one is easier? Obviously, the first one! Since entering the automobile sector requires extensive capital and time as well, the sector has barriers to entry. The higher the barriers to entry in the industry, the greater will be the benefits for the existing companies. Another example can be a chemical business where government approvals and licensing are important, which is quite time-consuming. Thus, there is a lesser threat of new entrants.
Threat of substitutes
If a company has few substitutes for its products, then it bears a favourable condition for pricing and supply. Let us consider, Pepsi and Coca-cola in cold drinks. If Pepsi increases its price, consumers might turn to coca-cola as it is the closest substitute. And hence, when there are many substitutes for a particular product, the company’s pricing power gets weakened.
Power of buyers
The number of buyers can have a significant impact on a company. A well-diversified client base puts a company in a comfortable position. On the other hand, if the client base is smaller and powerful, they might negotiate lower prices thereby, impacting the profitability of the company. Usually, IT companies have high client concentration, which can be a warning sign for investors.
Power of suppliers
Currently, in India, input costs have been on the rise, and that is affecting the manufacturing-intensive companies, which are unable to pass on the increased costs to the buyers. If there are few suppliers in the industry, naturally, they would dominate the input costs. As an investor, it is important to be watchful about the raw material suppliers.
These were Porter’s five forces, which is a fundamental model, mostly used during top-down analysis. This model’s power lies in its simplicity and wide application such that, it can be used in analysing almost every industry.