Porter’s Five Forces
A Framework for Competitive Strategy Analysis
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A key part of Harding Loevner’s investment process is to analyse the industry in which a company operates. Guided by the belief that whether a business thrives or not depends largely on the competitive structure of its industry.
The framework for this analysis is Harvard University professor Michael Porter’s Five Forces, which were first introduced in a 1979 issue of Harvard Business Review and later detailed in his 1980 book, Competitive Strategy: Techniques for Analyzing Industries and Competitors.
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Overview
The Bargaining Power of Buyers
The Bargaining Power of Suppliers
The Threat of Substitutes
The Threat of New Entrants
The Rivalry Among Existing Companies
The Five Forces help identify the competitive dynamics in an industry. These forces are:
Bargaining Power of Buyers
The bargaining power of buyers (or customers) is for when buyers pit the industry participants against each other to try to negotiate lower prices and/or higher quality goods or services.
When the buyers are more concentrated than the companies they are buying these goods or services from, they hold more bargaining power than the industry being analyzed, which can lead to lower profits in the industry.
Additional Context
Think: is the bargaining power of buyers too strong to raise prices?
Subcomponents to consider:
- Buyer concentration vs. firm concentration
- Buyer volumes
- Buyer information
- Ability to backward integrate
- Substitute products
- Pull through
Bargaining Power of Suppliers
The bargaining power of suppliers focuses on industry participants’ ability to capture economic value for themselves, as well as how much of that value needs to go to suppliers to create the products or services in an industry.
The more suppliers there are, the lower the input costs for a company and, therefore, the greater profits participants can create.
Additional Context
Think: is it easy for the industry to negotiate prices with suppliers?
Subcomponents to consider:
- Differences of inputs
- Switching costs
- Presence of substitute inputs
- Supplier concentration
- Threat of forward integration
- Cost relative to total purchase
- Impact of inputs on cost or differentiation
Threat of Substitutes
The threat of substitutes, or substitution risk, is when a customer either does something themselves, goes with a used rather than a new version of a product, or uses a product from another industry.
A substitute provides the same or a similar service as an industry product through a different means.
Substitute products or services limit an industry’s overall profit potential unless the industry participants are able to differentiate and fend off substitution risk through product performance, marketing, or other means.
Additional ContextThink: what are the other products or services that can substitute for what is offered by the industry?
Subcomponents to consider:
- Switching costs
- Relative price performance of substitutes
- Buyer propensity to substitute
- Threat of forward integration
- Cost relative to total purchase
- Impact of inputs on cost or differentiation
Threat of New Entrants
The threat of new entrants is when potential new entrants may come into an industry and compete with the incumbents. If an industry has a high barrier to entry, the stronger an incumbent’s competitive advantage.
Additional Context
Think: what is the likelihood of a new entrant coming into the industry?
Subcomponents to consider:
- Economies of scale
- Access to distribution
- Proprietary product differences
- Brand identity
- Switching costs
- Capital requirements
Rivalry Among Existing Companies
Rivalry among existing companies looks at competition between existing businesses in an industry.
The intensity of this force can be influenced by many factors, such as the maturity of the industry, price competitiveness, product or service differentiation, and more. The more rivalry within an industry, the harder it will be for a company to achieve profitable growth.
Additional Context
Think: what is the competitive landscape among companies within the industry?
Subcomponents to consider:
- Industry growth
- Fixed costs/value added
- Intermittent overcapacity
- Product differences
- Brand identity
- Switching costs
- Concentration and balance
- Informational complexity
- Diversity of competitors
- Corporate stakes
- Exit barriers
In Conclusion
For over 40 years, Michael Porter’s Five Forces framework has been used to help those analyzing industries and the companies within them. While other strategic analysis methods, such as SWOT Analysis and the Delta model, provide unique and valuable insights into a business, Porter Forces look beyond a company and into its industry, offering a wider view of external factors that may impact a company’s ability to thrive.
It is important to note that the Porter Forces aren’t solely based around the question, “Is this company attractive because of this specific force?” These forces work in conjunction with each other. No single force determines the health of an industry. Only by analyzing all five forces can an industry’s strengths and weaknesses be determined. It’s imperative to objectively analyze each of the forces to understand the long-term trends within an industry.
This content was originally published and created by Harding Loevner.