If you’ve ever heard Warren Buffett talk about investing, you’ve heard him mention the idea of a company moat. The moat is a simple way to describe a company’s competitive advantages. Companies with a strong competitive advantage have large moats and therefore higher profit margins. And investors should always worry about profit margins.
This article discusses a methodology called Porter’s Five Forces Analysis. In his book Competitive Strategy, Harvard professor Michael Porter describes five forces that affect the profitability of companies. These are the five forces he pointed out:
- Intensity of rivalry among existing competitors
- Threat of entry of new competitors
- Substitute product pressure
- Bargaining power of buyers (customers)
- The power of provider’s negociation
These five forces, taken together, give us an idea of a company’s competitive position and profitability.
rivals
Rivals are competitors within an industry. Rivalry in the industry can be weak, with few competitors not competing very aggressively. Or it can be intense, with many competitors fighting in a cutthroat environment.
The factors that affect the intensity of the rivalry are:
- Number of companies: More companies will lead to more competition.
- Fixed costs: With high fixed costs as a percentage of total cost, companies must sell more products to cover those costs, increasing competition in the marketplace.
- Product Differentiation: Products that are relatively the same will compete on the basis of price. Brand identification can reduce rivalry.
New entries
One of the defining characteristics of competitive advantage is the industry’s barrier to entry. Industries with high barriers to entry are often 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 into a market is lowered. As more companies enter a market, you will see rivalry increase and profitability drop (theoretically) to the point where there is no incentive for new companies to enter the industry.
Here are some common barriers to entry:
- Patents – Patented technology can be a huge barrier preventing other companies from joining the market.
- High cost of entry – The more it will cost to get started in an industry, the higher the barrier to entry will be.
- Brand Loyalty – When brand loyalty is strong within an industry, it can be difficult and expensive to enter the market with a new product.
alternate products
This is probably the most overlooked and therefore most damaging element of strategic decision making. It is imperative that business owners (us) not only look at what the company’s direct competitors are doing, but also at what other types of products people might buy instead.
When switching costs (the costs a customer incurs to switch to a new product) are low, the threat of substitutes is high. As is the case when it comes to new entrants, companies can aggressively price their products to keep people from switching. When the threat of substitutes is high, profit margins will tend to be low.
buyer power
There are two types of buying power. The first is related to the customer’s price sensitivity. If each brand of a product is similar to all the others, then the buyer will base his purchase decision primarily on price. This will increase competitive rivalry, resulting in lower prices and lower profitability.
The other type of buying power is related to bargaining power. Larger buyers tend to have more influence with the company and can negotiate lower prices. When there are many small buyers of a product, all else being equal, the company supplying the product will have higher prices and higher margins. Conversely, if a company sells to a few major buyers, those buyers will have significant leverage in negotiating better prices.
Some factors that affect buyer power are:
- Buyer size: Larger buyers will have more power over suppliers.
- Number of Buyers – When there are a small number of buyers, they tend to have more power over suppliers. The Department of Defense is an example of a single buyer with a lot of power over suppliers.
- Purchase Quantity: When a customer purchases a large quantity of a supplier’s output, they will exercise more power over the supplier.
Provider Power
Buying power analyzes the relative power that a company’s customers have over it. When several suppliers produce a basic product, the company will make its purchasing decision based mainly on price, which tends to reduce costs. On the other hand, if a single supplier is producing something that the company must have, the company will have little influence in negotiating a better price.
Size also plays a factor here. If the company is much larger than its suppliers and buys in large quantities, the supplier will have very little bargaining power. Using Wal-Mart as an example, we find that suppliers are powerless because Wal-Mart buys in such large quantities.
Some factors that determine provider power include:
- Supplier Concentration: The fewer the number of suppliers for a given product, the more power they have over the company.
- Switching costs: Providers become more powerful as the cost of switching to another provider increases.
- Product uniqueness: Vendors that make products specifically for a company will have more power than commodity vendors.
It is important to analyze these five forces and their effect on the companies in which we want to invest. Porter’s Five Forces Analysis will give you a good explanation of the profitability of an industry and the companies that comprise it. If you want to know why a company may or may not make a decent profit, this is the first analysis to do.