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Understanding Porter’s Five Forces

Porter’s five forces is the most famous concept in strategy, and is a part of every business undergrad/MBA curriculum. The concept is a succinct yet brilliant way of describing the competitive forces in an industry. For banking, it is an immensely useful framework for industry analysis, a key part of most stock pitches or research reports.

Porter’s five forces stems from Michael Porter, a Harvard educated economist. He developed the framework in part to explain why firms in perfectly competitive industries still made positive economic profit. In essence, the framework considers competition to not only be from the other players in the industry, but also from customers, suppliers, potential entrants, and substitutes. All five groups of agents exert competitive pressures that firms in the industry must navigate in order to remain profitable.

Threats of Entry

New entrants to an industry can exert significant pressure on the incumbents, by bringing new technologies, an entrepreneurial drive, and new capacity. Good examples of new entrants are Tesla to the automobile industry or AirBnB to the hotel industry. When you consider threads of entry, you must consider:

  1. Barriers to entry
  2. Response from incumbents

Barriers to entry keep new entrants at bay, some barriers are:

  • Economies of scale or scope: large incumbents operate at a size-related cost advantage to smaller entrants
  • Brand awareness and equity: incumbents built strong brands that customers remain loyal to, and any entrants will incur significant customer acquisition costs to gain market share
  • Large fixed costs: industry requires large capital expenditures
  • Learning or experience curve: incumbents built cost advantages derived from knowledge and experience in the industry
  • Distribution channels: incumbents built strong relationships with wholesalers and retailers, and any entrants will need to displace those relationships
  • Regulatory conditions: incumbents protected by the availability of licenses, tokens or any other government regulations

Competitive reaction from incumbents also dissuades new entrants. Incumbents could use their significant financial resources to push entrants out, using techniques such as lowering prices or flooding the markets with their products.

Changing Conditions

As time passes, certain conditions may change, affecting the barriers to entry and therefore the threat of new entrants. For example, when patents expire on drugs, generics flood the markets and erode the profitability of the branded drug. Alternatively, when new technologies allow companies to achieve better economies of scale, the threat of new entrants may decrease.

Strategic actions may also affect barriers to entry, the simplest example may be patents or other legal barriers. Other examples may be integration to achieve better scale, or expand distribution to block access to certain channels. However, with the proliferation of E-commerce, distribution channels have become more difficult to block.

Threat of Substitute Products

Substitute products place an upper limit on the prices an industry can charge to its customers: customers can always choose to buy the substitute if your products are too expensive. Unless the agents in the industry are able to differentiate their product from its substitutes, the industry will suffer in growth and profitability.

Power of Suppliers

Suppliers can exert pressure on agents in an industry by raising prices or controlling volumes. Depending on the power of the suppliers, companies in the industry can have their profits eroded by these pressures. The suppliers are powerful if they:

  • Are consisted of a few large companies, with a higher concentration than the industry
  • Produce relatively differentiated goods, so buyers cannot simply use goods from another supplier
  • Have high switching costs, so buyers prefer not to switch unless absolutely necessary
  • Have the ability to integrate forward and acquire a buyer
  • Do not prioritize the industry that the buyers’ are in, as the buyers do not form a large share of the suppliers’ revenues

Power of Buyers

We cannot talk about the power of suppliers without talking about the power of buyers. The two are inextricably linked, as if the industry can pass on any price changes from suppliers to its buyers, the power of suppliers is significantly weakened. Likewise, if the industry can negotiate better rates with suppliers if buyers demand a different price, the power of buyers is also weakened. Like suppliers, the power of buyers can put pressure on prices or demand more goods. The buyers are powerful if they:

  • Are consisted of a few large buyers that buy in high volumes, usually with large volume discounts
  • Purchase undifferentiated goods that can be easily substituted away from, which makes the producers less critical
  • Purchase goods that form a significant portion of their costs, which makes them more price sensitive
  • Generate low profits, which makes them more price sensitive
  • Purchase goods that are less important to their operations, which makes the producers less critical
  • Have the ability to integrate back and acquire a producer

These factors are applicable to both retail and commercial buyers.

Buyer Selection

One of the most common strategic decisions, choosing relatively weak buyers is — holding all else equal — a good strategic decision. It is rare that all buyers in an industry have equal power — segments of weaker buyers usually exist. By looking for buyers that do not fulfill the conditions listed above, a company can maintain higher than normal profitability. However, this is not to say that companies that sell to powerful buyers cannot make above average profits, if the products they sell have differentiated or unique features.

Industry Rivalry

Rivalry among companies in the industry is the classic form of competition — they compete on price, quantity, or brand power. The rivalry is defined by these factors:

  • Numerous competitors similar in size and power
  • Slow industry growth with competition fighting for higher growth
  • Products in the industry lack differentiation
  • Low variable costs which incentivize price competition
  • Perishable goods which need to be sold by a certain date
  • Capacity with large step function increases
  • High exit barriers that facilitate competition at low, or even negative profitability

The competitive landscape changes drastically with the industry life cycle. As growth slows in an industry, companies that enjoyed high growth will seek ways to maintain that growth rate, usually at the expense of other companies.

Finance 101Statistical Inference and Hypothesis Testing · Understanding Porter’s Five Forces · Modern Portfolio Theory and the Capital Allocation Line · Accounting Estimates: Managing Earnings · M&A Deal Case Study · Introduction to Enterprise Value and Valuation · Accounting Estimates: Recognizing Assets · Accounting Estimates: Recognizing Expenses · Accounting Estimates: Recognizing Revenue · Understanding Market Structure — Perfect Competition, Monopoly and Monopolistic Competition · Marginal Costs and Marginal Revenue · Analyzing Financial Statements and Ratios · Understanding the Three Financial Statements · Option Contracts and Put Call Parity · Fama French and Multi Factor Models · Understanding the Yield Curve · Bond Valuation and Arbitrage · Central Banks and Monetary Policy: The Federal Reserve · CAPM – Capital Asset Pricing Model · Inflation and Interest · Annuities and Perpetuities · Net Present Value · Understanding Supply and Demand ·

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