Porter's 5 Forces Analysis



Industry analysis is a type of investment research that begins by focusing on the status of an industry or an industrial sector.

Why is this important? Each industry is different, and using one cookie-cutter approach to analysis is sure to create problems. Imagine, for example, comparing the P/E ratio of a tech company to that of a utility. Because you are, in effect, comparing apples to oranges, the analysis is next to useless.

In each section we'll take an in-depth look at the different valuation techniques and buzz words used in a particular industry, complete a 5-forces analysis on the state of the market and point you in the direction of industry-specific resources.

Porter's 5 Forces Analysis

If you are not familiar with the five competitive forces model, here is a brief background on who developed it, and why it is useful.

The model originated from Michael E. Porter's 1980 book "Competitive Strategy: Techniques for Analyzing Industries and Competitors." Since then, it has become a frequently used tool for analyzing a company's industry structure and its corporate strategy.

In his book, Porter identified five competitive forces that shape every single industry and market. These forces help us to analyze everything from the intensity of competition to the profitability and attractiveness of an industry. Figure 1 shows the relationship between the different competitive forces.

1.    Threat of New Entrants - The easier it is for new companies to enter the industry, the more cutthroat competition there will be. Factors that can limit the threat of new entrants are known as barriers to entry.

2.    Power of Suppliers - This is how much pressure suppliers can place on a business. If one supplier has a large enough impact to affect a company's margins and volumes, then it holds substantial power. Here are a few reasons that suppliers might have power:

·    Existing loyalty to major brands
·    Incentives for using a particular buyer (such as frequent shopper programs)
·    High fixed costs
·    Scarcity of resources
·    High costs of switching companies
·    Government restrictions or legislation

3.    Power of Buyers - This is how much pressure customers can place on a business. If one customer has a large enough impact to affect a company's margins and volumes,
then the customer hold substantial power. Here are a few reasons that customers might have power:

·    There are very few suppliers of a particular product
·    There are no substitutes
·    Switching to another (competitive) product is very costly
·    The product is extremely important to buyers - can\'t do without it

·    The supplying industry has a higher profitability than the buying industry

4.    Availability of Substitutes - What is the likelihood that someone will switch to a competitive product or service? If the cost of switching is low, then this poses a serious threat. Here are a few factors that can affect the threat of substitutes:

·    Small number of buyers
·    Purchases large volumes
·    Switching to another (competitive) product is simple

·    The product is not extremely important to buyers; they can do without the product for a period of time

·    Customers are price sensitive

5.    Competitive Rivalry - This describes the intensity of competition between existing firms in an industry. Highly competitive industries generally earn low returns because the cost of competition is high. A highly competitive market might result from:

·    The main issue is the similarity of substitutes. For example, if the price of coffee rises substantially, a coffee drinker may switch over to a beverage like tea.

If substitutes are similar, it can be viewed in the same light as a new entrant.

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