Analyzing Stocks with Porter’s Five Forces

As an investor, I always try to research the company thoroughly before buying its stock. I am fairly conversant with the P/E Ratio, Return on Equity Ratio, Price to Book Ratio, Dividend to Price Ratio, and Debt to Equity Ratio that can help me understand the financials of the company.

However, do these ratios paint the entire picture? Somewhere I felt that the analysis was missing the qualitative aspect. This was until I was introduced to the world of Michael Porter’s Five Forces to determine if a company has a sustainable competitive advantage.

Today, I will talk about how you can use the Five Forces concept to analyze stocks.

What are Porter’s Five Forces?

You might wonder what is porter's five forces. Porter’s Five Forces can help you analyze the competitiveness of a business environment. Porter believed that there are several temporary factors like technical innovations, growth rates, etc. that affect the businesses in a sector.

However, to understand it thoroughly, you need to analyze the fundamental position of the company in its industry. This position can be understood with the help of the following five competitive forces:

1. Rivalry in the industry
2. The threat of new entrants in the industry
3. The threat of substitutes
4. The bargaining power of buyers
5. The bargaining power of sellers

Let’s look at each of them in detail:

1. Rivalry in the Industry

We know that competition is good for the market. It keeps the businesses on their toes and offers competitive prices to consumers. However, the intensity of the competition can affect the performance of every company in a given sector.

According to Porter, the competition is the most intense when the following conditions are met:

• There are numerous competitors and most of them have similar size and value.
• The growth is slow causing a rush for a major share of the market.
• The products or services offered by all companies in the sector are homogeneous. This makes it easier for a consumer to switch from one provider to another increasing the chances of poaching.
• In sectors where the product is perishable and/or the fixed price is very high, companies are tempted to cut prices.
• If a company wants to increase its output, it needs to do so in large increments for the expansion to be cost-efficient.
• The exit barriers are very high.
• The competitors are a highly diverse lot with different goals and personalities.

While I can talk about each point in great detail, the crux of it is that in most market segments competitors pose an internal threat to each other to maintain balance and prevent monopoly.

And, the points mentioned above can help you understand the extent of rivalry in the sector. Before buying a stock, you must ensure that you understand the position of the company in its sector with respect to its competitors. 

2. The Threat of New Entrants in the Industry

Porter lays a lot of emphasis on the barriers to entry in any industry. In simpler terms, this means the difficulties that a new company can face to gain entry. These barriers can include huge capital/infrastructure requirements, need for a large distribution network, patents, etc.

Imagine a company launching a path-breaking product/service in a particular industry. If the barriers to entry are low, then new firms can easily surpass them and replicate the business model turning competitors.

This will be seen in their share prices too as this ground-breaking product/service will fail to provide profits for long.

3. The Threat of Substitutes

Substitute products/services are not from the same market segment. There are some products and/or services where customers can easily switch to substitute products. Hence, when the demand for one increases, the other experiences a drop.

This can impact the performance of the company and the investor perception not allowing the share price to truly flourish. For example, if the price of coffee increases, then the coffee drinker might move to tea or another beverage.

Hence, before buying the share of a company, look at the products and services offered and the substitutes available in the market. Based on this observation, you will be able to assess how well the company is positioned to manage any substitute product/service threatening its profits.

Also, companies that have fewer or no substitutes tend to price their products/services higher and have high stock prices.

4. The Bargaining Power of Buyers

The bargaining power of buyers is the ability of buyers to drive prices down. According to Porter's five forces model, buyers can force sellers for better pricing under the following conditions:

• The market is concentrated or purchases are made in large volumes.
• The company offers products that are standardized or undifferentiated. For example, in the paper industry, most manufacturers create standardized products. Hence, buyers can form a manufacturer to sell at market prices.
• Some companies purchase products from other companies and resell them at low margins. Hence, they can push the prices lower.

You can assess the bargaining power of buyers by assessing the concentration of buyers, volume of transactions, sensitivity of customers, etc. This can help you understand how the profits of the company that you are looking to invest in can get impacted in the long-term.

5. The Bargaining Power of Suppliers

Many small and mid-sized companies face a threat from an industry where the suppliers hold bargaining powers.

Imagine a restaurant that has a special dish that is making it famous but needs a specific ingredient available only with a handful of suppliers. In such cases, the suppliers can raise the prices which will impact the final price of the dish and impact the restaurant’s business.

However, large corporations usually are unaffected by this power since they have the resources to establish a wide supplier network and create the bargaining power of buyers instead.