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Porter's 5 forces
In the previous chapter, we saw what SWOT analysis is and how it helps investors like you pick the right stocks. In this one, we’re going to take a look at another method for analyzing a business - Porter’s 5 forces. Let’s begin the chapter with a brief history of this method and then segue into the five forces.
The history of Porter’s 5 Forces
First conceptualized by Micheal E. Porter of Harvard University, the framework of Porter’s 5 forces is basically a method that’s used to analyze the competition of a business. According to Porter, one of the main reasons that led to the development of this analysis framework was the lack of thoroughness of the SWOT analysis.
Micheal Porter realized that the SWOT analysis only gave an idea of the company’s strengths, weaknesses, opportunities, and threats. And that it completely disregarded other major microeconomic factors that contribute to the performance of a business, such as its competition. Therefore, he set out to create a detailed framework based on Industrial Organization (IO) economics that allowed analysts to easily determine the overall market competitiveness and consequently the level of attractiveness of an industry.
After much deliberation, Porter identified 5 major forces that are capable of impacting the profitability of a business. And by adequately understanding these various forces that can impact profitability, he firmly believed that a business could adjust its strategy for better results. Porter’s 5 forces was first published in 1979 in the Harvard Business Review, and have, since then, been used quite extensively and successfully by many businesses to build, improve, and revamp their business strategy for long-term profitability.
Understanding Porter’s 5 Forces
The 5 forces as identified by Micheal Porter are:
- Industry competition
- Threat of new entrants
- Power of suppliers
- Power of buyers
- Threat posed by substitute products
Let’s take a look at each of the 5 forces one after the other and try to understand the logic behind their inclusion.
1. Industry competition
According to Porter, the competitiveness of an industry has a major impact on the profitability of the businesses operating in it. And so, it is important for a business to have an adequate understanding of its rivals. Some of the factors that need to be considered are the number of competitors, their strength, and the products and services that they provide. Generally, the more the number of rivals, the less the power of a business operating in that industry. For instance, when the rivalry in an industry is intense, it could lead to aggressive marketing tactics and price slashes, which could very well impact the overall profitability.
That’s not all. When a business faces many rivals, its customers and suppliers could easily gravitate towards other companies if they don’t get the right price. Conversely, a business with minimal competitors has the distinct advantage of being able to charge high prices from its customers and simultaneously push for better deals from its suppliers.
2. Threat of new entrants
Another major force that has the potential to impact the overall profitability of a business is the ability of new entrants to disrupt the industry. If an industry has low barriers of entry and allows new entrants to easily establish their business with little capital and time, the position of a business in that industry is likely to be weaker.
This is because new entrants are more likely to come into the industry with all guns blazing with fresh capital, aggressive price cuts, and new marketing strategies. This can end up eating into the profits of an existing business. Alternatively, if there are high barriers of entry such as high capital requirements, long gestation periods, or strict governmental regulations that restrict the insurgence of new entrants, an existing business is more likely to retain its profitability.
3. Power of suppliers
The number of suppliers of materials in an industry determines the ability of a company to remain unaffected by the rise in prices of the various inputs. For instance, if an industry has a large number of suppliers to choose from, there most likely would be an aggressive pricing mechanism in place, allowing a business to take advantage of low input prices.
Also, with more suppliers to choose from, a business can easily switch from one to another in the event of a price rise. On the other hand, if the input materials used by a business are unique or limited, the number of suppliers is likely to be very low. Such a situation gives more power to the suppliers, allowing them to charge higher input costs, which can consequently lower the profits of the business.
4. Power of buyers
Just like how suppliers play a huge role in a business’ ability to generate profits, the buyers and customers of a business also enjoy a similar power. According to Micheal Porter, the customers’ ability to drive the prices of products and services manufactured or offered by a business is another major force affecting profitability.
Here’s an example. Assume that there’s a business with a small customer base. Due to the size of this loyal audience, the business would have to work extra hard to retain the existing customers by offering lower prices or discount programs. This could end up reducing their profit margin by quite a bit. Alternatively, if a business has a large customer base, it can afford to charge higher prices to enhance its profit margin without losing too many of its customers.
5. Threat posed by substitute products
The last and final force that Micheal Porter identified as an influence on a business’ profitability is the threat posed by substitute goods and products. What this essentially means is that a business whose products and services have substitutes that are like-for-like in nature is constantly under threat, since its customers always have the option to switch if they ever feel that the business doesn’t offer them a fair deal.
And so, the business would be forced to weaken its position in the industry to cater to its customers and to prevent them from choosing substitute products. For example, Fanta and Mirinda, Coke and Pepsi, and Sprite and 7up - all of these are like-for-like That said, a business whose products and services don’t have any substitutes that are like-for-like in nature can demand a higher price for its products and stay secure knowing that its customers would most likely not exit their market.
An example of the 5 forces in action
Let’s take up an example to get a better understanding of how to use Porter’s 5 forces model to analyze a company. For this example, we’ll use the OTT content platform Netflix. But before we start analyzing its business, here’s a quick overview of the company.
Incorporated in 1997, Netflix started its business off by renting and selling movie DVDs through the mail. However, as the popularity of the internet started to soar, Netflix branched out to streaming movie and TV show content online through its website. And as the DVD business started to fall out of favour, the company discontinued it and moved completely digital. Currently, Netflix is available worldwide except for a few countries, with offices in the USA, India, Brazil, Japan, and Korea, among others.
Now that you’ve gotten an idea of the company, let’s move on to our analysis.
Threat of new entrants
Power of suppliers
Power of buyers
Threat of substitute products
As you can see from the above example, analyzing a business through Porter’s 5 forces model gives you a deep insight into the overall profitability. With this, we’ve come to the end of this chapter. In the next, we’re going to be looking at the concept of market share and why it is important for a business.
A quick recap
- First conceptualized by Micheal E. Porter of Harvard University, Porter’s 5 forces is basically a method that’s used to analyze the competition of a business.
- According to Porter, one of the main reasons that led to the development of this analysis framework was the lack of thoroughness of the SWOT analysis.
- The 5 forces as identified by Micheal Porter are Industry competition, threat of new entrants, power of suppliers, power of buyers and the threat posed by substitute products.
- According to Porter, the competitiveness of an industry has a major impact on the profitability of the businesses operating in it.
- Another major force that has the potential to impact the overall profitability of a business is the ability of new entrants to disrupt the industry.
- The number of suppliers of materials in an industry also determines the ability of a company to remain unaffected by the rise in prices of the various inputs.
- The last and final force that Micheal Porter identified as an influence on a business’ profitability is the threat posed by substitute goods and products.