As an investor, we read and analyse financial statements before investing in a company. We use various financial ratios to check a company’s financial health. But is that enough?
Does it provide us a complete picture of the company? How do you decide if a company has a sustainable competitive advantage? You can use Porter’s Five Forces Model to check the quality of a company and industry. The model is also applied to understand the competition within the industry.
Porter’s Five Forces are:
- Competition in the industry
- New entrants threat
- Power of suppliers
- Power of customers
- Threat of substitute products
A Brief History:
The Five Forces model is named after Michael E. Porter, a Harvard professor. It was first published in his book Competitive Strategy in 1980. He is a recipient of the Wells Prize in Economics, three McKinsey Awards, and is the author of 14 books.
Porter shows how competitive advantage can be connected to profitability. He presents a new perspective on the company’s quality analysis. Porter’s framework is still relevant for predicting competitor behavior even after forty years of publication.
It is broadly used to analyse the industry structure and its corporate strategy. These five forces are frequently used to measure the competition strength, attractiveness, and profitability.
Let’s learn how we can use these forces in our research process:
1. Competition in the industry
Competition keeps companies on their toes. It motivates them to perform better. Before buying a stock, you must understand the position of the company in its industry.
The larger the number of competitors, the lesser is the power of a company. Conversely, low competition means that the company has greater pricing power. It gives them the power to set the terms of deals to achieve higher profits.
For example, India is the third-largest domestic aviation market in the world. The switching costs for customers is also very low. Hence there is cut-throat competition in the Indian aviation sector.
Questions you must ask:
- How many competitors does the company have?
- What is the market capitalization of the industry?
- At what rate is it growing?
- Compare the company’s growth with its competitors.
- Compare their global presence.
- What are the switching costs for customers?
- What are the barriers to exit?
This will give us an overview of the entire industry. You will find most of this company-specific information in their Annual Report. Using this, we will be able to map out the structure and its attractiveness.
2. Threat of New Entrants
This refers to the difficulties a company faces when a new player enters the industry. New entrants face many barriers while starting up a new business. These include setting up a distribution network, huge capital, infrastructure requirements, patents, etc.
Industries with high entry barriers have few competitors. While industries with low entry barriers have lots of players and thus don’t have a high-profit margin.
For example, assume that a company is about to launch a new product in a market. If the barriers to entry are low, then a new start-up can easily try to replicate the product. This would lead to an increase in competition and a further rise in expenses. The stock price would see no huge impact despite a new product launch.
In the airline industry, new entrant’s threats can be considered as low to medium. The Indian government has approved 100% Foreign Direct Investment (FDI). However, new entrants need licenses and huge upfront investment. Plus, the existing airline players have built up a large base of experience over the years. Thus, a new entrant would have a competitive disadvantage right from the start.
Questions to ask:
- Are there any legal barriers to entry?
- How much capital is required to enter the industry?
- How do existing companies respond to new entries?
The less time and money it costs for a rival to enter a market, the greater would be the threat of new business. An industry with strong entry barriers is ideal for companies.
3. Power of Suppliers
It addresses how suppliers influence and affect profitability. . Fewer the suppliers, the more dependent a company becomes. . As a result, suppliers have more power and can drive up input costs to take undue advantage. When there are many suppliers, the switching costs are low.
For example, the airline industry majorly depends on fuel and aircrafts. The prices of fuel are subject to fluctuations in the global market. The industry has very little control over these factors. Very few aircraft suppliers exist which gives them bargaining power. Suppliers can raise the prices which can impact the entire industry
Questions to ask:
- How many suppliers are there in the industry?
- What is the financial strength of each supplier?
- What is the cost of switching to alternative materials?
However, large companies are rarely affected by this. They have a better profit margin than others. They also have the ability to establish their own supplier network.
4. Power of Customers
You cannot run a business without customers. They have the power to force sellers for better price deals and services. The bargaining power of buyers is their ability to influence and drive down the prices of goods and services. The force largely depends on how many customers a company has and how significant each customer is.
Questions to ask:
- How many potential buyers are there for a particular industry?
- What is the size of each sale?
- What is the cost associated with a buyer switching a supplier?
- How many substitutes exist?
- Are buyers sensitive to price changes?
For example, the bargaining power of customers in the airline industry is considered to be high. Customers have various tools to compare different prices and offers. They will always prefer to go with the least expensive option. Plus, they do not incur any switching costs to change airways.
5. Threat of Substitutes
Availability of substitute goods and services is also a major threat. Products with no close substitutes have high pricing power. When close substitutes are available, customers have the option to switch to a cheaper product.
Substitution can be within the industry or outside the industry.
For example, a customer can decide to travel by road instead of booking a flight. Various factors like cost, safety, time, etc. contribute to making a decision. Air travel is relatedly costlier in India which makes railway a feasible substitute. In India, the railway connects remote cities making travel cheaper and accessible.
Given the pandemic situation, flight services have declined dramatically. People prefer traveling short distances by car. So, the threat of substitutes in the airline industry can be viewed as medium to high.
Questions to ask:
- How many substitutes exist for the company’s products and/or services?
- How are the substitutes performing?
- What cost do customers have to bear while switching to substitutes?
Before investing in a company, look at the products and services offered. Check for their substitutes and their performance. Observe if they are in a position to handle substitutes threatening its profits.
Let your first step be to understand and gather the relevant information. Using the data, you will be able to check the company’s position in the industry.
This is a qualitative parameter that is often ignored by most investors. Start observing each aspect to determine how each force impacts the company. Use this table for quick reference to analyse the attractiveness –
Investors often depend too much on financial ratios without giving importance to industry threats. Understand these forces before you start examining a company. It will help you learn more about a company and make better investment decisions.
It would also help you improve your strategy to increase profitability. Umesh Mehta who is the CEO of Samco Asset Management Ltd. believes that investors must focus on the quality of a company rather than returns.
Watch this video to learn about the most important lesson he has learned over the years.
You could avoid investing in mediocre companies if you use Porter’s Five Forces Model. You can visit our stock page to collect important analytics of a company and its competitors. Open a Demat account with SAMCO and start investing your money smarty.
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