Why is it that some companies grow and thrive for 50 or 100 years, while others are highly successful for just a few years before fizzling out? The answer is that some companies have a durable competitive advantage, while for others competition quickly chips away at growth and profit.
In a 1979 article in Harvard Business Review professor Michael Porter introduced a framework for evaluating a company’s competitive position and strategy that came to be known as Porter’s Five Forces. The five forces help to show why a company is profitable so that you can judge whether that profitability will last. The framework has become an important tool for corporate management, consultants and investors.
In valuing a company, investors will usually try to predict whether the company’s margins will increase, decline or stay the same. The five forces are a helpful tool for this part of valuation. The framework helps you hone in on the company’s strategy as well is the larger industry dynamics that effect profitability.
The following is a brief description of the five forces with a few examples:
Threat of new entrants/barriers to entry
If the existing companies in an industry benefit from lasting barriers to entry they will have a more durable competitive advantage. Any very profitable business will attract competition that undercuts profit. Barriers to entry are what prevent or slow down this process. A common example is economies of scale, which give large companies a cost advantage over competitors. Another is the “network effect” of having an established platform of users that is difficult to replicate. This is an advantage of well-established social networks like Facebook or Twitter. A strong brand or long term patents can also help establish barriers to entry.
Threat of substitutes
Threat of substitutes is fairly straightforward, but sometimes it’s hard to predict all the possible substitutes because they might be a seemingly unrelated product. First tablets and then even smartphones became substitutes for personal computers. The ride hailing app Uber hopes that its service will become a substitute for owning cars. More essential products like toothpaste or bread are less likely to face the threat of substitutes. Companies can fight against the threat of substitutes by differentiating their products.
Bargaining Power of Buyers
Bargaining power is another way of saying pricing power. When a product is non-essential and the consumer has lots of options, the consumer has high bargaining power and so the seller has low pricing power. On the other hand, if the buyer only has one or two options and product is essential, the seller has the ability to raise prices without losing much market share. So when buying phone service from AT&T and Verizon, the buyer has low bargaining power. Phone service is essential to many people, and there are few options. The buyer has more bargaining power when buying something like candy bars. They are non-essential and easily substituted and there are many choices.
Bargaining Power of Suppliers
Think of the suppliers of Walmart. Often Walmart is by far the biggest customer of these suppliers. By partnering with Walmart they can grow their business enormously. These companies have low bargaining power and low pricing power. This is a big part of Walmart’s competitive advantage, and it allows the company to get better prices from its suppliers than smaller competitors. The opposite situation can be seen with Google’s smartphone software Android. For smartphone makers (other than Apple) Android is virtually the only game in town. This means that Google has high bargaining power. (While Google doesn’t actually charge money for Android, they exploit the bargaining power by using the software to promote other Google products.)
Competition Among Existing Companies in the Industry
The final force sums up of the impact of the other forces to evaluate the overall competition of the existing companies in the industry. In thinking about industry rivalry it is important to research how concentrated the industry is and how much market share the leading companies have. You might also analyze the strategies of other participants. Are they growing by acquisition, competing on cost, differentiating their products or expanding to new markets?
The five forces may appear to be just common sense, but the framework is not as obvious as it might seem. For example, many people would identify a company with superior technology to have a strong competitive advantage. Porter, however, sees technology as a fleeting factor rather than a durable one. Many investors have learned this lesson the hard way when first movers in a new technology are eventually overtaken by competition. Advantages that come from government regulation are also not included as one of the five forces because the government can change the rules at any time. This is not to say that you should disregard the impact of technology or regulation, but rather consider it to be a less durable or secondary source of competitive advantage.
When evaluating investment candidates it is tempting to just extrapolate whatever is going on now into the future, assuming that a company’s profitability and competitive position will remain the same. In our fast-changing economy, however, successful investing requires that you consider what is likely to happen five or ten years down the road. Using Porter’s Five Forces, helps to evaluate where the company is headed in the future, taking into account its strategy and competitive position.