Porter’s Five Forces: A Comprehensive Guide | CFA Level I Equity Investments

In this lesson, we dive into industry analysis with the classic starting point: Porter’s Five Forces. Let’s explore each force and how they affect the competitive environment.

Porter’s Five Forces: The Determinants of Competition

According to Porter, the five determinants of the intensity of competition in an industry are:

1. Rivalry among existing competitors
2. Bargaining power of buyers
3. Bargaining power of suppliers
4. Threat of new entrants
5. Threat of substitutes

1. Rivalry Among Existing Competitors

Rivalry depends on the industry’s competitive structure. For example:

• Industries dominated by a few large players may have less competition.
• Fragmented industries with many similar-sized firms may have more competition.

Other factors affecting rivalry include:

• Industry growth
• Fixed costs
• Product differentiation

EXAMPLE: The auto industry has high fixed costs due to capital investments and labor contracts. This leads to large production volumes, low margins, and intense competition.

2. Bargaining Power of Buyers

Buyers can influence pricing in some situations, such as when:

• There are few buyers with large orders.
• Buyers have strong negotiation power.

EXAMPLE: In the aircraft parts industry, few manufacturers exist, so customers can be tough negotiators on prices.

3. Bargaining Power of Suppliers

Suppliers can limit supplies and raise prices when:

• There are few suppliers.
• Materials are scarce.

Employees, as suppliers of labor, can also have bargaining power in heavily unionized industries.

4. Threat of New Entrants

The threat of new entrants depends on barriers to entry, such as:

• High capital requirements
• Regulatory approval

EXAMPLE: The telecommunications industry has high barriers to entry due to significant capital investments and regulatory licenses required to operate.

5. Threat of Substitutes

Substitutes can satisfy needs with different products, limiting an industry’s pricing power. A higher number of viable substitutes may cause customers to seek alternatives if prices increase.

EXAMPLE: Coach companies in Europe have limited pricing power as travelers can choose other modes of transport like budget airlines or trains.

Barriers to Entry

Barriers to entry determine the threat of new entrants into an industry. High barriers protect existing firms and can lead to:

• Greater pricing power
• Increased profitability
• Less competition

EXAMPLE: The global credit card industry, dominated by MasterCard and Visa, has high barriers to entry due to capital requirements and the need for a large network. This preserves their profitability.

Not All High Barrier Industries Have Pricing Power

Some high barrier industries have limited pricing power due to:

• Price-sensitive customers
• Commodity products
• High barriers to exit

EXAMPLE: The airplane manufacturing industry, dominated by Boeing and Airbus, has high barriers to entry but limited pricing power due to price-sensitive customers and competition between the two companies.

EXAMPLE: The oil refining industry has high barriers to entry but limited pricing power due to commodity products and high barriers to exit.

Low Barrier Industries and Pricing Power

Industries with low barriers to entry often have little pricing power because:

• New competitors can easily enter
• Price increases attract new entrants

EXAMPLE: The restaurant industry has low barriers to entry, making it highly competitive with limited pricing power.

Analyzing Ease of Entry

An analyst can assess the ease of entry into an industry by:

1. Determining how easily a new entrant could obtain the capital, intellectual property, and customer base needed to succeed.
2. Examining the composition of the industry over time, considering whether the same firms dominate now as they did ten years ago.

Changing Barriers to Entry

Barriers to entry can change over time due to:

• Regulatory changes
• Technological advancements

EXAMPLE: The semiconductor industry used to have high barriers to entry, but technology advancements now allow chip designers to outsource manufacturing, making entry easier.

Industry Concentration

Industry concentration refers to the distribution of market share among existing competitors. A concentrated industry has:

• A few dominant players
• Lesser competition
• Greater pricing power

EXAMPLE: The global soft drinks industry, dominated by Pepsi and Coca-Cola, is concentrated with less competition and significant pricing power.

Exceptions to the Rule

Some concentrated industries may not have greater pricing power due to:

• Comparable market share among competitors
• Undifferentiated or commodity-like products
• High barriers to exit

EXAMPLE: The airplane manufacturing industry, dominated by Boeing and Airbus, is concentrated but with fierce competition due to comparable market share.

EXAMPLE: The automobile industry, dominated by players like Toyota, Volkswagen, and Ford, is concentrated but with weak pricing power due to undifferentiated products and high barriers to exit.

Fragmented Industries

A fragmented industry is characterized by:

• Many firms of relatively equal size
• High competition
• Limited pricing power

EXAMPLE: The airline industry is fragmented with limited pricing power and narrow profit margins due to the absence of a dominant market share holder.

Industry Capacity

Industry capacity refers to the supply of the product or service offered by an industry. It can be:

• Overcapacity: Supply is greater than demand, leading to lower prices and return on capital.
• Undercapacity: Supply is less than demand, resulting in pricing power and higher return on capital.

An analyst should examine an industry’s current and planned capacity, taking into account economic cycles and potential time lags between investment and output.

Time Lag Factors

The time lag between deciding to increase capacity and actual increased production depends on:

• Whether the product is physical or non-physical
• The time required to gather resources, labor, and materials

EXAMPLE: Increasing airline capacity requires a longer time lag as it needs additional planes, pilots, and crew.

EXAMPLE: Increasing insurance capacity can be quick, as financial capital can be easily shifted.

Market Share Stability

Market share stability affects the level of competition and pricing power in an industry. Variable market shares indicate high competition, while stable market shares suggest less intense competition.

Factors affecting market share stability include:

• Barriers to entry
• Product innovations
• Switching costs

High switching costs contribute to market share stability and pricing power, as seen with iPhones and their loyal user base.

Industry Life Cycle

Industries typically go through 5 main stages:

1. Embryonic Stage
2. Growth Stage
3. Shakeout Stage
4. Mature Stage
5. Decline Stage

Each stage has its own characteristics and challenges. Let’s briefly explore each one.

1. Embryonic Stage

This is where the industry is just starting. Growth is slow, prices are high, competition is limited, and risk of failure is high.

2. Growth Stage

At this stage, demand grows rapidly. Prices fall due to economies of scale, and competition remains limited as the market expands.

3. Shakeout Stage

Here, growth in demand slows down, excess capacity develops, and competition intensifies as firms battle for market share.

4. Mature Stage

During this stage, demand growth stagnates, and the industry often consolidates into oligopolies. Firms focus on maintaining market share and profitability.

5. Decline Stage

In this stage, demand growth turns negative due to factors like technological substitution or globalization. Competition remains intense as firms struggle to survive in a shrinking market.

While industry life cycle analysis is a helpful tool, it has its limitations. Industries may not always conform to this framework, and life-cycle stages can be affected by external factors like technological disruptions, government regulations, societal changes, or demographic shifts.

Price Competition

To analyze price competition, consider the customer’s perspective. Customers typically value a mix of attributes, such as price, brand value, reliability, switching costs, and product quality. Industries where price is a significant factor tend to be more price competitive, while those where customers value other attributes exhibit less price competition.

EXAMPLE: The automobile industry faces some price competition, but luxury goods companies like Louis Vuitton and Prada have significant pricing power due to their customers’ focus on quality and brand value.