Porter’s Five Forces: A Comprehensive Guide | CFA Level I Equity Investments
Welcome back! 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:
- Rivalry among existing competitors
- Bargaining power of buyers
- Bargaining power of suppliers
- Threat of new entrants
- 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.
Analyzing the Industry
An analyst can examine the industry by focusing on:
- Barriers to entry
- Industry concentration
- Industry capacity
- Market share stability
- Industry life cycle
- Price competition
We’ll explore these characteristics in subsequent lessons.