Porter's Five Forces

What are Porter’s Five Force?

Porter’s Five Force is a model that identifies and analyses five competitive forces that shape every industry. The Five Forces model is named after Harvard Business School professor, Michael E. Porter. It helps analyzing the level of competition within a certain industry. It also helps determine an industry's weaknesses and strengths. Porter's model can be applied to any segment of the economy to understand the level of competition within the industry and enhance a company's long-term profitability. The collective strength of these forces determines the profit potential of an industry and thus its attractiveness.
 

Understanding Porter’s Five Forces

Porter's five forces include three forces from 'horizontal' competition – competition rivalry, the threat of new entrants and the threat of substitute products or services – and two others from 'vertical' competition – the bargaining power of suppliers and the bargaining power of customers. Competitive rivalry and threat of new entrant are arguably the most important Porter’s Five Forces and thus we will try to dive deep into these two factors.

1) Competitive Rivalry

Competitive rivalry refers to the strength of competition among the existing(incumbent) firms in an industry. It means how fiercely the firms compete against each other.
Industry concentration is a strong indicator of competitive rivalry. For example, one of the most popular and reliable measures of industry concentration is the Herfindahl-Hirschman Index (HHI). HHI is measured by the summation of squares of all the market share of firms. Higher HHI indicates high concentration and thus reflects lower competition. Conversely, low HHI indicates low concentration which means high competition. To know more about HHI Click Here.

Homogeneity is another factor that influences competitive rivalry. Homogeneity refers to similarities in goal, corporates philosophies and ownership structure. But there are instances where companies have different objectives. For example, an industry having both private and public held company. Public company aims to maximize social welfare and private company aims to maximize profit. Such differences in their corporate philosophy increases competitive rivalry.

Asset specificity plays a role in rivalry. Specific assets encourage a company to stay in an industry even when conditions become trying because there is no alternative use for the assets. For example, airline industry faces the problem of asset specificity as aero planes and cargo planes cannot be used for any other purpose.

A final consideration in rivalry is industry growth. When the industry is growing, competitors can increase its shareholder value without undermining competitors. This is not a zero-sum game. Whereas if the industry’s growth is stagnant, only way for a company to increase its shareholders wealth is by taking market share from competitors. So a rise in competitive rivalry often accompanies decelerating industry growth rate.
 

2) Threat of New Entrant

A company faces threat of new entrant when barriers to entry are low. Barriers to entry are the hindrances that make it difficult for new companies to enter a given industry.

Economics of scale is an important source of barriers to entry. When significant economies of scale are present, average production cost gets lowered as the output increases. If existing companies in an industry has exploited economics of scale to an extent that it becomes difficult for a new entrant to achieve that output level. This deters the entry of new entrant.

Another important shaper to barriers to entry is the magnitude of entrant’s expected payoff. An entrant cannot be sure about earning profits if existing players have insurmountable advantage. These advantages come from precommitment contracts, licenses, patent and learning curves. Precommitment contract helps a company to secure its future earnings. A company may have to acquire costly license from government to do business. If a company has a patent for a particular product, then competitors cannot copy that product. Learning curve refers to the ability to reduce per unit cost of product without capitalizing on economies of scale. This is possible due to cumulative experience of the company. All these creates a barrier for an entrant.

Brand loyal plays a vital role in deterring entry of new entrant. A strong brand creates loyal customers. A company can enhance its brand loyalty through heavy advertisement expenditure. This discourages new entrants.

Network effect is another factor that restricts new entrant. It works on the formula that existing and satisfied customers brings more customers which in turn creates a wide network of customers. It works on the principle of ‘word of mouth’. As more people use a company’s product, the value of product or services increases for both new and existing users.
 

3)Threat of Substitutes

Substitutes are those goods or services that can be used in place of a company's products or services. For example, Pepsi is a substitute for Coca-Cola. Substitution threat addresses the existence of substitute products or services, as well as the likelihood that a potential buyer will switch to a substitute product. A business faces a substitution threat if its prices are not competitive and if comparable products are available from competitors. Substitute products limit the prices that companies can charge, placing a ceiling on potential returns.
 

4) Bargaining Power of Supplier

Supplier power is the degree of leverage a supplier has with its customers in areas such as price, quality, and service. An industry that cannot pass on price increases from its powerful suppliers is destined to be unattractive. Suppliers are well positioned if they are more concentrated than the industry they sell to, if substitute products do not burden them, or if their products have significant switching costs. They are also in a good position if the industry they serve represents a relatively small percentage of their sales volume or if the product is critical to the buyer. Sellers of commodity goods to a concentrated number of buyers are in a much more difficult position than sellers of differentiated products to a diverse buyer base.

5) Bargaining Power of Buyer

Buyer power is the bargaining strength of the buyers of a product or service. Informed, large buyers have much more leverage over their suppliers than do uninformed, diffused buyers.  It is affected by how many buyers or customers a company has, how significant each customer is, and how much it would cost a company to find new customers or markets for its output. A company having large number of small and independent seller can easily charge higher price without much impact on sales. But, a company with small customer base where each customer presents a large proportion of sales then customers have the power to negotiate for lower price.
 
 
Interpreting Porter’s Five Forces

If the five forces are intense (for example airline industry), almost no company in the industry earns attractive returns on investments. An investor should remain away from investing companies of such industries. If the forces are mild however (for example soft drink industry), there is room for higher returns. An investor should consider investing in such industry and they have a chance for higher returns.
 
 
To warp up,

Porter’s five forces are frequently used to measure competition intensity, attractiveness, and profitability of an industry or market. An investor should consider investing in industries with mild five forces. Along with Porter, we should also perform PESTLE and SWOT analysis and do our own exhaustive research to understand industry structure.
 
Happy Investing!
 

Disclaimer: Companies used as an example in this blog are for educational purposes and not an investing advice.