Porter's Five Forces Analysis

If you've ever listened to Warren Buffett talk about investing, you've heard him mention the idea of ​​a canal company. The canal is a simple way of describing competitive advantages of a company. Company with a strong competitive advantage have large moats, and therefore higher profit margins. And investors should always be concerned with profit margins.

This article looks at a method called the Porter's Five Forces Analysis. In his book Competitive Strategy, Harvard professor Michael Porter describes five forces that corporate profitability. These are the five forces he noted:

Intensity of rivalry among existing competitors
Threat of entry of new competitors
Pressure from substitute products
Bargaining power of buyers (customers)
Bargaining power of suppliers
These five forces, taken together, give us insight into a company's competitiveness and profitability.

Rivals

Rivals are competitors within an industry. Rivalry in the industry can be weak, competing with few competitors who do not very aggressive. Or it can be intense, with many competitors fighting in a cutthroat environment.

Factors affecting the intensity of rivalry are:

Number of enterprises - more companies will lead to more competition.
Fixed costs - with high fixed costs as a percentage of total costs, companies need to sell to cover those costs, increasing competition in the market more products.
Product differentiation - Products that are relatively the same will compete based on price. Brand identification can reduce rivalry.
Newcomers

One of the defining characteristics of competitive advantage of the industry's barrier to access. Industries with high barriers to entry are usually too expensive for new companies to enter. Industries with low barriers to entry are relatively cheap for new firms to enter.

The threat of new entrants increases as the barrier to entry is reduced into one market. As more companies enter the market, will see you rise rivalry and profitability will fall (theoretically) to the point where there is no incentive for new companies to enter the industry.

Here are some common barriers:

Patents - patented technology can be a huge obstacle other companies from entering the market.
High cost of entry - the more it will cost to get started in an industry, the higher the barrier to entry.
Brand loyalty - when brand loyalty is strong within an industry, it can be difficult and expensive to enter a new product market.
Substitute Products

This is probably the most overlooked, and therefore most harmful part of the strategic decision-making. It is imperative that business owners (us) not only look at what the company's direct competitors are doing, but what other types of products people could buy instead.

When switching costs (the costs which a customer is switching to a new product on) are low the threat of substitutes is high. As is the case when dealing with newcomers, businesses can aggressively pricing their products to keep switching people. When the threat of substitutes is high, profit margins tend to be low.

Copper Power

There are two types of purchasing power. The first relates to the customer price sensitivity. If any brand of a product is equal to all others, then the buyer will purchase decisions based mainly on price. This will increase. The competition, resulting in lower prices and lower profitability

The other type of buyer power relates to negotiating position. Larger buyers tend to have more influence at the firm, and can negotiate reduced rates. When there are many small buyers of a product, all other things being equal, the company that the product will have higher prices and higher margins. Conversely, if a company sells to a few large customers, those buyers will have significant leverage to negotiate better prices.

Some factors affecting buyer power are:

Size of copper - more buyers will be more power over suppliers.
Number of buyers - if a small number of buyers, they tend to have more power over suppliers. The Ministry of Defence is an example of a single buyer with a lot of power over suppliers.
Purchase quantity - When a customer purchases a large amount of a suppliers output, will exercise on the supplier the more power.
Supplier Power

Power buyer looks at the relative power of customers a company has more than. When multiple vendors are producing a commoditized product, the company will buy its decision primarily based on price, which tends to lower costs. On the other hand, if a single supplier is something the company should have produced, the company little leverage to negotiate a better price.

Size plays a factor here as well. If the company is much larger than its suppliers, and purchases in large quantities, then the supplier will have a very limited power to negotiate. Using Wal-Mart as an example, we find that suppliers have no power, because Wal-Mart purchases in such large quantities.

A few factors that determine supplier power are:

Supplier concentration - The fewer the number of suppliers for a given product, the more power they have over the company.
Switching costs - suppliers become more powerful as the cost to change to another supplier increases.
Uniqueness of product - suppliers that produce products specifically for a company will have more power than suppliers of raw materials.
It is important to these five forces and their impact on companies we want to invest in. The Porter Five Forces analysis will give you a good explanation for the profitability of an industry and analyze. Companies within this If you want to know why a company is able, or unable, to make a decent profit, this is the first analysis you should do....