Understanding Porter's Five Forces

Understanding Porter's Five Forces

 

The tool was created by Harvard Business School professor Michael Porter, to analyze an industry's attractiveness and likely profitability. Since its publication in 1979, it has become one of the most popular and highly regarded business strategy tools. Porter recognized that organizations likely keep a close watch on their rivals, but he encouraged them to look beyond the actions of their competitors and examine what other factors could impact the business environment. He identified five forces that make up the competitive environment, and which can erode your profitability. They are as follows...

Competitive Rivalry. This looks at the number and strength of your competitors. How many rivals do you have? Who are they, and how does the quality of their products and services compare with yours? Where rivalry is intense, companies can attract customers with aggressive price cuts and high-impact marketing campaigns. Also, in markets with lots of rivals, your suppliers and buyers can go elsewhere if they feel that they're not getting a good deal from you. On the other hand, where competitive rivalry is minimal, and no one else is doing what you do, then you'll likely have tremendous strength and healthy profits.

Supplier Power. This is determined by how easy it is for your suppliers to increase their prices. How many potential suppliers do you have? How unique is the product or service that they provide, and how expensive would it be to switch from one supplier to another? The more you have to choose from, the easier it will be to switch to a cheaper alternative. But the fewer suppliers there are, and the more you need their help, the stronger their position and their ability to charge you more. That can impact your profit.

Buyer Power. Here, you ask yourself how easy it is for buyers to drive your prices down. How many buyers are there, and how big are their orders? How much would it cost them to switch from your products and services to those of a rival? Are your buyers strong enough to dictate terms to you? When you deal with only a few savvy customers, they have more power, but your power increases if you have many customers.

Threat of Substitution. This refers to the likelihood of your customers finding a different way of doing what you do. For example, if you supply a unique software product that automates an important process, people may substitute it by doing the process manually or by outsourcing it. A substitution that is easy and cheap to make can weaken your position and threaten your profitability. 

Threat of New Entry. Your position can be affected by people's ability to enter your market. So, think about how easily this could be done. How easy is it to get a foothold in your industry or market? How much would it cost, and how tightly is your sector regulated? If it takes little money and effort to enter your market and compete effectively, or if you have little protection for your key technologies, then rivals can quickly enter your market and weaken your position. If you have strong and durable barriers to entry, then you can preserve a favorable position and take fair advantage of it.

Key Points

 

Porter's Five Forces Analysis is an important tool for understanding the forces that shape competition within an industry. It is also useful for helping you to adjust your strategy to suit your competitive environment, and to improve your potential profit.
It works by looking at the strength of five important forces that affect competition:

• Supplier Power: the ability of suppliers to drive up the prices of your inputs.
• Buyer Power: the strength of your customers to drive down your prices.
• Competitive Rivalry: the strength of competition in the industry.
• The Threat of Substitution: the extent to which different products and services can be used in place of your own.
• The Threat of New Entry: the ease with which new competitors can enter the market if they see that you are making good profits (and then drive your prices down). 

By thinking about how each force affects you, and by identifying its strength and direction, you can quickly assess your position.
You can then look at what strategic changes you need to make to deliver long-term profit.

When dealing with emerging growth stocks (micro and small cap), the usual static valuation tools do not really apply (P/E, P/B, P/S, P/CF). The intrinsic value of these companies lies in management's ability to grow and develop the business for the future. That being said an investor should focus on the business model of the company and the nature of the industry in which it competes. This is where Porter's Five Forces come into play. A third factor to consider with these young growing companies is management's ability to allocate their shareholder's capital efficiently and responsibly. Management is a critical element when investing in the small cap arena.