Porter’s 5 forces is a model that helps to identify and analyze 5 competitive forces that are linked to the company’s profitability.
The tool was created by Harvard Business School professor Michael Porter to analyze an industry’s attractiveness and likely profitability. Since its publication in 1979, it has become one of the most popular and highly regarded business strategy tools.
Porter acknowledged that organizations are likely to watch their rivals closely, but he encouraged them to look beyond their competitors’ actions and examine what other factors could impact the business environment. He identified five forces that make up the competitive environment that can hurt your profitability.
Porter’s 5 forces help explain why different industries are able to maintain different levels of profitability.
We as investors can use this model to compare different stocks and identify which has the greatest competitive advantages and which has the best chance of a brighter future.
Industry competition
Analyze the number and strength of your competitors. How many rivals do you have? Who are they and how does the quality of their products and services compare to yours?
Where rivalry is intense, companies can attract customers with aggressive price cuts and high-impact marketing campaigns. Also, in markets with many rivals, your suppliers and buyers may go elsewhere if they feel they are not getting a good deal from you.
On the other hand, where competitive rivalry is minimal and no one else does what you do, you are likely to have tremendous strength and healthy profits.
Suppliers’ bargaining power
It is determined by how easily your suppliers raise their prices. How many potential vendors do you have? How unique is the product or service they provide and how expensive would it be to switch from one supplier to another?
The more you choose, the easier it will be to switch to a cheaper alternative. But the fewer suppliers there are and the more you need their help, the stronger your position and ability to charge more. This can affect your profit.
Buyers’ bargaining power
Here, you wonder how easy it is for buyers to lower their prices. How many buyers are there and how big are their orders? How much would it cost them to switch from their products and services to those of a rival? Are your buyers strong enough to dictate terms to you?
When you deal with just a few more experienced clients, they have more power, but their power increases if you have a lot of clients.
The threat of substitute products
This refers to how likely your customers are to find a different way of doing what you do. For example, if you provide a unique software product that automates an important process, people can replace you by running the process manually or by outsourcing it. An easy and cheap replacement to make can weaken your position and threaten your profitability.
The threat of new entrants
Your position can be affected by people’s ability to enter your market. So, think about how easily this can be done. How easy is it to get a foothold in your industry or market? How much would it cost and how rigid is your sector?
If you need little money and effort to enter your market and compete effectively, or if you have little protection for key technologies, rivals can quickly enter your market and weaken your position. If you have strong and durable barriers to entry, you can preserve a favorable position and take advantage of it.
Happy investing!