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The Usefulness Of Porters Five Forces In Analyzing Companies: Part 1

Previously, I wrote about using SWOT analysis and PEST analysis as tools for company analysis. Another very useful tool is the Porter”s Five Forces model developed by Michael E. Porter in 1979 to assess the level of competition surrounding a business.

As competition is an important aspect of any investment analysis of a company, the Porter’s Five Forces model can be used to effectively size up a company’s competition and assess the key characteristics of the industry which the company is in. The Five Forces are, in no particular order of importance: (i) Threat of new entrants; (ii) Threat of substitutes; (iii) Industry rivalry; (iv) Bargaining power of customers; and (v) Bargaining power of suppliers. I shall cover the first three aspects of Porter’s model in this article and the remaining two in a subsequent article.

Threat of new entrants

Companies which are highly profitable would inadvertently attract competitors who are eager to grab a slice of the lucrative pie. If there is a huge influx of firms which offer a similar product or service, it could erode the profitability of the entire industry as there is only a limited pool of customers.

There are many factors which can determine how threatening new entrants may be, but the main consideration would be whether they have a superior product or offering which may draw customers away from the incumbent market leader. In industries which are price-sensitive, new entrants may also severely erode industry-wide profitability if they engage in price-cutting. As investors, we thus have to assess the level of risk new entrants may pose to a company based on industry characteristics, and whether the industry is concentrated (i.e. dominated by only a few players) or fragmented (i.e. many players with each having only a small market share).

Threat of substitutes

A substitute product or service is one which can replace another due to increased efficiency, lower cost, or other reasons. An example would be smart phones with cameras, which are substitutes for digital cameras. Even drinking water can be considered a substitute for soft drinks.

We have to assess if there are new technologies or advancements which could create a demand for substitute products, thus rendering existing products obsolete. The level of threat of substitutes would also depend on a customer’s switching cost, which is defined as how much trouble and money a customer has to incur to switch to a substitute product.

Industry rivalry

The intensity of rivalry amongst competitors within an industry would also determine an industry’s attractiveness. Rivalry can be classified as “rational” if all players maintain their market share and do not try to under-cut one another – this usually happens in an oligopoly, where there are two or three major players, and no one wants to disrupt the existing peaceful equilibrium.

Irrational rivalry would involve price wars, where competitors seek to gain market share by discounting their products aggressively. Such behaviour is usually a characteristic of industries that involve commodity products or services where price is the most important criteria for selection among customers.

Stay tuned for the follow-up article where I cover the remaining two aspects of the Porters Five Forces model! [Editor’s note: Part 2 of this two-part series has been published and it can be found here.]

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