How to analyse industry and company using porter’s five forces?

Using Porter's Five Forces framework can help you make informed investment decisions

Porter's Five Forces analysis is a popular framework for analyzing a stock's competitive environment. It differs from other methods by focusing on the industry's competitive forces and identifying key drivers of profitability. It is superior because it helps investors understand a company's strategic positioning within its industry, assess investment risk, and make more informed investment decisions.

Porter's Five Forces is a framework developed by Michael Porter in 1979 that helps to analyse the competitive environment of an industry. It identifies five key forces that shape the competitive landscape of an industry and affect its profitability.

Using Porter's Five Forces framework can help you make informed investment decisions by providing a structured approach to analyzing the competitive environment of an industry and evaluating the potential risks and opportunities associated with investing in a particular company or industry.

The five forces are:

1. Threat of new entrants
2. Bargaining power of suppliers
3. Bargaining power of buyers
4. Threat of substitutes
5. Intensity of competitive rivalry

Let’s understand the framework in detail:

1. Threat of new entrants

The threat of new entrants refers to the possibility of new companies entering a specific industry and competing with incumbent ones. A high level of threat from new entrants indicates that new companies can enter the market very easily, reducing the profitability of existing companies. This threat can be considerably reduced if the industry has high entry barriers, limiting the ability of new companies to compete with the incumbent company.

E-commerce, for example, has lowered the barriers to entry for many retail enterprises, making it simpler for new companies to enter the market and compete with established brick-and-mortar retailers. As a result, many traditional retailers have struggled to retain their market share and profitability in the face of increased competition from online retailers.

On the other hand, the pharmaceutical industry has significant entry barriers due to the intensive research and development required to create new treatments, tight regulations, and high expenses related to acquiring patents. As a result, new companies entering the market have significant barriers in developing and selling new products, making it difficult to compete with established giants such as Pfizer, Merck, or Novartis. As a result, the threat of new competitors in this market is quite minimal.

2. Bargaining power of suppliers

Supplier bargaining power refers to the degree of control suppliers have over the price and quality of inputs provided to a company. A supplier with significant bargaining power can raise costs or reduce quality, affecting a company's overall profitability. A supplier with less bargaining power, on the other hand, may be forced to accept lower pricing or deliver higher-quality supplies in order to keep the buyer.

The oil and gas industry is one example of a supplier with significant bargaining power. Because there are few substitutes for oil and the costs of switching to alternative inputs are considerable, companies that extract crude oil have significant bargaining power. This permits oil companies to charge high prices for their oil and holds considerable influence over the price of fuel and other petroleum-based products.

A supplier with low bargaining power, on the other hand, has many competitors or provides products that are not essential to the business. A company that uses office supplies, for example, can readily switch between suppliers without substantial effects because there are many suppliers offering identical products at competitive prices. In such a circumstance, the supplier's bargaining power is relatively minimal, allowing the buyer to negotiate favourable terms and pricing.

3. Bargaining power of buyers

Buyer bargaining power refers to the amount of control a buyer has over the price and quality of products or services purchased from a business. Buyers with strong bargaining power can demand lower pricing, higher quality, and better conditions from suppliers, which can affect a company's profitability.

For example, large retail chains in India, such as Dmart and Reliance Retail, have significant bargaining power over small manufacturers and suppliers due to their dominant market position and control over the retail market. These retail chains can dictate the terms of the contracts, including prices, delivery schedules, and payment terms, that manufacturers and suppliers need to accept in order to supply their products to these retail chains.

A buyer with less bargaining power, on the other hand, has few alternative suppliers or is heavily reliant on a single supplier. For example, a small business that relies on a single supplier for a critical input may have little bargaining power if there are no other suppliers offering comparable products. In such a case, the supplier may charge higher prices or provide lower-quality inputs, which can have a significant impact on the business's profitability.

4. Threat of substitutes

The threat of substitutes refers to the availability of other products or services that can meet the same demand or function as a company's offerings. When there are many substitutes, a company may feel pressure to differentiate itself by offering better value to its customers.

The soft drink industry is an example of a business that faces a high threat from substitutes. Many customers regard soft drinks as replaceable products, and there are other alternatives available, such as bottled water, juice, and tea. This means that soft drink businesses must differentiate themselves through branding, marketing, and product innovation to maintain their market share and profitability.

5. Intensity of competitive rivalry

Intensity of competitive rivalry refers to the degree of competitiveness and aggressiveness among existing companies in a given industry. Companies must constantly innovate and compete with one another to maintain market share and profitability due to the high level of intense rivalry.

One example of high intensity of competitive rivalry can be seen in the automobile industry. There are several automobile manufacturers that operate in the same market, including Maruti Suzuki, Hyundai, Tata Motors, Mahindra and Mahindra, and Honda. These manufacturers compete on several factors, including product design, quality, safety, performance, and pricing.

Conclusion

Porter's Five Forces framework is a valuable tool that businesses can use to analyze the competitive environment of an industry and identify opportunities and threats. In addition to that, there are many ways one can apply the framework for making investment decisions:

1. Identifying potential acquisitions: By analysing an industry's competitive environment and identifying companies with strong competitive positions and growth potential, the framework can assist you in identifying potential acquisition targets.
2. Evaluating investment risks: You can identify potential risks to your investment by analysing the competitive environment, such as new entrants or substitutes that may disrupt the industry or intense competition that may impact profitability.
3. Assessing market trends: The framework can assist you in identifying market trends and competitive environment shifts that may have an impact on your investment. For example, if the bargaining power of suppliers or buyers grows, it may indicate an industry shift that will affect your investment.
4. Developing investment strategies: Based on your competitive environment analysis, you can develop investment strategies that capitalise on opportunities while mitigating risks. For example, if you identify a company with a strong competitive position and potential for growth, you may want to consider investing in that company to capitalise on its growth potential.