The Five Forces
of Competition
Date Added: October 20th,
2004
By Charles Worthman
" We would
rather own a great business at a fair price than bad a business
at a great price" - Warren Buffet
These words have always been an issue for me. After
all, it seems that we spend so much time worrying about discount
rates, analysts' projections
,and discounted cash flow valuations. Who has time to try and go
through the very hard, time-consuming task of not just analyzing
the financial statements but the entire business structure as well?
Unfortunately
we are never really taught how to evaluate a business. After all,
long-term competitive advantage doesn't quite have the same
appeal as easy-to-package ratios like a P/E ratio or book value.
Yet for those of us who invest in the market, analyzing this is
perhaps one of the most important and left-out steps in buying a
share in a company. Sure the price you pay is important but
in the end the sad truth is that no one knows what any one company
is going to earn in the future. So how do we figure out if
a company has the prospects we are looking for without an MBA? Michael
Porter of Harvard University and author of Competitive Advantage
developed the best method I know of. It is called the 5 forces of
competition and it tells us in a nutshell the 5 things we must determine
when evaluating a business's profitability in the future. These
are as follows.
1. Threat of entry
This is how easy it is for a firm to enter the industry that your
company is in. This is important because any industry worth looking
at should earn above average returns. Those returns ultimately attract
competitors who want to earn those high returns as well. However,
when too many competitors join the fray it eventually drives prices
and returns down and makes the industry unattractive. Usually companies
that can protect themselves (also known as having a moat around
their business) are either business that require high investment
to enter (like Aerospace or Oil), have important brands (like Coke),
have high switching to change (like Microsoft) or have a patent
barring competitors (like drugs)
2. Bargaining power of suppliers
Companies who have only a few suppliers can't bargain with them
or play one off another for better prices. This
leads to higher priced inputs
and dilutes returns (like airlines).
3. Bargaining power of buyers
This is affected by how big your customers are and how much revenue
they constitute as well as other things. For instance Wal-Mart has
a lot of power with suppliers because it buys so much of their inventory
and is thus a large percent of those companies revenues. It is no
surprise then that these companies have lived and died with Wal-Mart's
orders and would do anything to protect their business with them.
4. Availability of substitutes
This is how easily people can find something else if you were to
raise prices or if they somehow found your offering unfavorable.
For instance, oil has no substitute to date. People either pay the
price or don't drive. Compare this with designer clothes, where
if the price goes up you can always buy low priced jeans instead.
For those of us who are economics students, this is also called
elasticity of demand.
5. Competitive rivalry
This is how competitive an industry is. For instance, if there are
lots of companies selling essentially the same products there will
always end up being a price war which will severely hurt the company'
profits. The wireless companies have had this problem for years
and fierce competition has made it tough for them to make a profit.
Now let's take a look at an example of how we can use
this when analyzing the cable industry.
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