Wall Street Prep

Porter’s 5 Forces Model

Guide to Understanding Porter’s 5 Forces Model

Learn Online Now

Porter’s 5 Forces Model

Porter’s 5 Forces Model Framework

The originator of the 5 Forces Model is Michael Porter, a Harvard Business School (HBS) professor whose theories remain instrumental to business strategy even today.

Porter’s 5 forces model framework is utilized for strategic industry analysis, and focuses on the following:

  1. Barriers to Entry – The difficulty in partaking in the industry as a seller.
  2. Buyer Power – The leverage held by buyers in being able to negotiate lower prices.
  3. Supplier Power – The ability of a company’s suppliers to increase the prices of its inputs (e.g. raw materials for inventory).
  4. Threat of Substitutes – The ease at which a certain product/service can be replaced, typically with a cheaper variation.
  5. Competitive Rivalry – The intensity of the competition within the industry – i.e. number of participants and the types of each.

Competitive industry structures can be analyzed utilizing Porter’s five forces model, as each factor influences the profit potential within the industry.

Moreover, for companies that are considering whether to enter a particular industry, a five forces analysis can help determine whether the profit opportunity exists.

If there are substantial risks making the industry unattractive from a profitability perspective and negative industry trends (i.e. “headwinds”), it may be better for the company to forgo entering a given new industry.

Industry Analysis of Competitive Dynamics

“Understanding the competitive forces, and their underlying causes, reveals the roots of an industry’s current profitability while providing a framework for anticipating and influencing competition (and profitability) over time.”

– Michael Porter

How to Interpret Porter’s 5 Forces Model (“Economic Moat”)

The premise of the 5 forces model is that for a company to obtain a sustainable, long-term competitive advantage, i.e. “moat“, the profitability potential within the industry must be identified.

However, identification is not sufficient, as it must be followed up with the right decisions to capitalize on the proper growth and margin expansion opportunities.

By analyzing the prevailing competitive environment, a company can objectively recognize where it currently stands within an industry, which can help shape corporate strategy going forward.

Certain companies will identify their competitive advantages and attempt to extract as much value as possible from them, whereas other companies might focus more on their weaknesses – and neither approach is right or wrong as it depends on each company’s particular circumstances.

1. Threat of New Entrants

Industries constantly undergo disruption or are prone to it, especially given the modern pace of technological growth.

Seemingly every year, new features or updates to existing technology are introduced to the market with claims of more efficiency and improved capabilities to accomplish difficult tasks.

No company is entirely protected from the threat of disruption, but differentiation from the market provides more control to the company.

Hence, many of the market leaders nowadays allocate a significant amount of capital each year into research and development (R&D), which makes it more challenging for others to compete while protecting themselves from being blindsided by new breakthrough technologies or trends.

Potential barriers to entry include:

  • Economies of Scale – Upon achieving greater scale, the cost of producing one unit declines, which provides a competitive advantage to the company.
  • Differentiation – By offering unique products/services to meet targeted customer needs, the greater the barrier to entry (i.e. higher customer retention, loyal customer base, more technical product development).
  • Switching Costs – Even if a new competitor offers a better product/service, the cost of switching to a different provider can deter the customer from switching (e.g. monetary considerations, inconvenience).
  • Patents / Intellectual Property (IP) – Proprietary technology can protect competitors from attempting to steal market share and customers.
  • Initial Required Investment – If the upfront cost of entering the market is high (i.e. significant capital expenditures required), fewer companies will enter the market.

2. Bargaining Power of Buyers

On the topic of the bargaining power of buyers, the first question to ask is if the company is:

  • B2B: Business-to-Business
  • B2C: Business-to-Consumer
  • Combination: B2B + B2C

In general, commercial customers (i.e. SMBs, enterprises) are more likely to have more bargaining power due to having more spending power, whereas everyday consumers typically have far less money to spend.

However, the universe of commercial clients is limited compared to that of consumers.

For reputable buyers with significant purchase volumes or order sizes, suppliers tend to be willing to accept lower offer prices to retain the customer.

By contrast, if a B2C company with millions of individual customers were to lose a single customer, the company would likely not even notice.

3. Bargaining Power of Suppliers

The bargaining power of suppliers stems from selling raw materials and products that other suppliers do not carry (i.e. more scarcity results in greater value).

If the items provided by the supplier constitute a significant proportion of the product as sold by the buyer, the bargaining power of the supplier directly increases, as the supplier is a major component of the buyer’s operations.

On the other hand, if the suppliers for a certain product are not differentiated, the competition will be more heavily based around pricing (i.e. a “race to the bottom” – which benefits the buyers, not the sellers).

4. Threat of Substitute Products/Services

Often, products or services can have substitutes that make them more vulnerable, as customers in these instances have more optionality.

More specifically, if a certain condition is met – e.g. an economic downturn – customers could opt for cheaper products despite lower quality and/or lower-tier branding.

5. Rivalry Among Existing Competitors

The degree of rivalry within an industry is a direct function of two factors:

  1. Size of the Revenue Opportunity – i.e. Total Addressable Market (TAM)
  2. Number of Industry Participants

The two are closely linked, as the greater the revenue opportunity, the more companies will enter the industry to grab a piece of the pie.

Furthermore, if the industry is growing, there are likely going to be more competitors (and vice versa for stagnant or negative growth industries).

Five Forces Model: Attractive vs. Unattractive Industries

Signs of a Profitable Industry

  • (↓) Low Threat of Entrants
  • (↓) Low Threat of Substitute Products
  • (↓) Low Bargaining Power of Buyers
  • (↓) Low Bargaining Power of Suppliers
  • (↓) Low Rivalry Among Existing Competitors

Signs of an Unprofitable Industry

  • (↑) High Threat of Entrants
  • (↑) High Threat of Substitute Products
  • (↑) High Bargaining Power of Buyers
  • (↑) High Bargaining Power of Suppliers
  • (↑) High Rivalry Among Existing Competitors
Step-by-Step Online Course

Everything You Need To Master Financial Modeling

Enroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks.

Enroll Today
Comments
guest
0 Comments
Inline Feedbacks
View all comments
Learn Financial Modeling Online

Everything you need to master financial and valuation modeling: 3-Statement Modeling, DCF, Comps, M&A and LBO.

Learn More
X

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.