Porter's Five Forces is a simple but effective framework for understanding a company's position and prospects in an economy. When developing assumptions for financial modeling exercises, Porter's five forces is a great starting point for testing the merits of your assumptions.
The five forces as described by Porter are:
Threat of New Entrants: If people see that an industry is earning above average risk adjusted returns, by competitive forces other parties will become interested in entering the industry to share in the excess profits until those profits are competed away. Things that can protect excess profits in an industry are:
This is not a conclusive list, but a good start. When examining a company in an industry that earns above normal returns on investment it is important to understand how that return is derived in order to be able to form a view of whether that return will continue or diminish.
Intensity of Competition: If there are numerous competitors in an industry then the prospects of earning an above average return are not substantial, as many competitors are vying for a limited number of sales. High competition leads to price reductions to compete for business, and price reductions will in turn reduce profitability. Conversely a monopoly participant can take the position of a price-setter in order to find an optimum supply level to maximise profits. Different types of industry competition levels include:
Threat of Substitutes: A company that produces redundant products or services will find it difficult or impossible to generate a sufficient return. Consider cassette manufacturers as an example. Previously some of these companies enjoyed strong returns while their technology was state of the art, but nowadays their market share has been competed away by more advanced products such as mp3 players, ipods and the like. Substitution can be a threat from a price stand-point as well as a technological stand-point. Consider the case of transportation. A consumer has the option of driving a car, riding a bike, catching public transport, walking or running, and their final choice will be decided by factors including time, cost and lifestyle choices. As such if one becomes uncompetitive from a price stand-point it runs the risk of losing market share to another alternative mode of transport. Substitution threats can emerge from:
Bargaining Power of Buyers: If customers to a company have many similar products to choose from, a favourable industry structure for the customer, and a low physical need for a product then the customer will have substantial bargaining power with the company in regards to the price of the product. If on the other hand there is a high need for a product, limited number of suppliers and the industry structure favours the producer, then the company will have much larger influence over the price. If the company can control or dictate prices it can increase returns, and if it cannot control or dictate prices then it will likely experience lower returns. Summary of bargaining power forces include:
Bargaining Power of Suppliers: If a company is reliant on a single supplier and has no alternatives then it will have to accept the price the supplier dictates and attempt to pass through this price to its own customers. This generally leads to lower returns for the company as it experiences higher costs. Conversely if the company has numerous choices for supplier because the input is created by numerous parties and/or is generic in nature then the company can force down the cost of its inputs. If a company has a strong negotiating position with its suppliers it can generally enjoy stronger returns than if it is a price-taker from its suppliers. Summary of bargaining forces include:
We recommend that analysts developing assumptions for a financial model use a similar framework, and in particular use this framework to compare assumptions about a company against broader industry trends to test for reasonableness.
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We hope you have enjoyed this post on Porter's Five Forces.