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.
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:
Let’s look at each of them in detail:
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:
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.
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.
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.
The bargaining power of buyers is the ability of buyers to drive prices down. According to Porter, buyers can force sellers for better pricing under the following conditions:
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.
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.
Once you have understood Porter’s five forces, you will be able to evaluate the company’s competitive position in the industry. This is a qualitative parameter that is usually ignored by most investors. Here are some pointers to help you use this tool efficiently.
The first step is to gather information about all the forces. Here are some factors that you need to gather information on:
This is where the ‘magic’ happens. Start analyzing each aspect carefully trying to determine how each force impacts the industry and the company that you are planning to invest in. Use this table for quick reference to analyze the attractiveness of an industry:
|Factor||Attractive Industry||Unattractive Industry|
|Barrier to Entry||High||Low|
|Bargaining power of suppliers||Weak||Strong|
|Bargaining power of buyers||Weak||Strong|
|Substitute products or services||Few||Many|
|Level of competition||Low||High|
Remember, an attractive industry means higher profits and hence better investor perception and higher share price.
Porter’s Five Forces is a great tool to analyze an industry and a company using qualitative parameters that are usually ignored. Understand each of these forces before you start analyzing. So, the next time you are researching a company for its stock, follow the list specified above and see if you can learn something more about the company that can help you make a better decision.