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Porter's Five Forces AnalysisIf you've ever listened to Warren Buffett talk about investing, you've heard him mention the idea of a company's moat. The moat is a simple way of describing a company's competitive advantages. Company's with a strong competitive advantage have large moats, and therefore higher profit margins. And investors should always be concerned with profit margins. This article looks at a methodology called the Porter's Five Forces Analysis. In his book Competitive Strategy, Harvard professor Michael Porter describes five forces affecting the profitability of companies. These are the five forces he noted:
These five forces, taken together, give us insight into a company's competitive position, and its profitability. Rivals Rivals are competitors within an industry. Rivalry in the industry can be weak, with few competitors that don't compete very aggressively. Or it can be intense, with many competitors fighting in a cut-throat environment. Factors affecting the intensity of rivalry are:
New Entrants One of the defining characteristics of competitive advantage is the industry's barrier to entry. Industries with high barriers to entry are usually too expensive for new firms to enter. Industries with low barriers to entry, are relatively cheap for new firms to enter. The threat of new entrants rises as the barrier to entry is reduced in a marketplace. As more firms enter a market, you will see rivalry increase, and profitability will fall (theoretically) to the point where there is no incentive for new firms to enter the industry. Here are some common barriers to entry:
Substitute Products This is probably the most overlooked, and therefore most damaging, element of strategic decision making. It's imperative that business owners (us) not only look at what the company's direct competitors are doing, but what other types of products people could 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 dealing with new entrants, companies may 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 buyer 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 the purchase decision mainly on price. This will increase the competitive rivalry, resulting in lower prices, and lower profitability. The other type of buyer power relates to negotiating power. Larger buyers tend to have more leverage with the firm, and can negotiate lower prices. When there are many small buyers of a product, all other things remaining equal, the company supplying the product will have higher prices and higher margins. Conversely, if a company sells to a few large buyers, those buyers will have significant leverage to negotiate better pricing. Some factors affecting buyer power are:
Supplier Power Buyer power looks at the relative power a company's customers has over it. When multiple suppliers are producing a commoditized product, the company will make its purchase decision based mainly on price, which tends to lower costs. On the other hand, if a single supplier is producing something the company has to have, the company will have little leverage to negotiate a better price. Size plays a factor here as well. If the company is much larger than its suppliers, and purchases in large quantities, then the supplier will have very little power to negotiate. Using Wal-Mart as an example, we find that suppliers have no power because Wal-Mart purchases in such large quantities. A few factors that determine supplier power include:
It's important to analyze these five forces and their affect on companies we want to invest in. The Porter Five Forces Analysis will give you a good explanation for the profitability of an industry, and the firms within it. If you want to know why a company is able, or unable, to make a decent profit, this is the first analysis you should do. Other articles by this author »
About Chris Mallon
Chris Mallon is the editor and publisher of the Undervalued
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And here is another random article you might be interested in... Impressing Your Customers Is Easy With 3 Guaranteed TacticsCustomer satisfaction isn't one single act, but a group of actions that work together to make their experience a pleasant and satisfying experience. You've probably eaten at a restaurant where the food was wonderful, but the service slow and unprofessional. Somebody was doing a good job, but your overall experience wasn't up to par. There are three areas of service that work together to impress your customers. Provide good service in these three areas, and they'll be back... time and time again. 1. Instant Response Let's face the facts... people just don't like to wait. When they walk out the door, they want to have the product at their fingertips. Hey, they may have taken weeks to decide on the purchase, but once the decision has been made, they want it NOW. The best way to make customers happy is to make the product available at the point of sale, but not all businesses are able to do that. Internet marketers obviously cannot provide immediate service, but can be sure to keep delivery time to an absolute minimum. 2. Make Buying Simple Keep the buying process as simple as possible. Customers are just like you, they hate paperwork. To an online customer, clicking on 20 different screens translates as paperwork. It's annoying, time consuming, and a turn off. Use the "easy as 1, 2, 3" idea as a selling point in your advertising campaign. Busy and tired customers take notice, and you'll see results! 3. Give Customers Personal Attention Good listeners are hard to come buy. The world is full of people trying to sell us something, or trying to persuade us to their viewpoint. You want to make an impact? Learn to listen to your customers. Make it easy to ask questions. Yeah, yeah, I know. That's time consuming and you don't have time to spare. But listen, you'll find that a lot of questions are repeated over and over again. Create a frequently asked question form, and you'll be able to answer a lot of consumer questions without sacrificing as much of your time. Copyright 2006 Cutts Group, llc Other articles by this author »
About Allyn Cutts
Who is Allyn Cutts, and why should you care? Allyn has spent over 24 years helping businesses like yours find new customers and increase sales to current customers. Allyn is a marketing and sales fanatic, providing measurable marketing solutions that drive huge results for small-to mid-size business clients. Allyn works personally with clients to design and deliver off-line and on-line direct marketing strategies that focus on metrics and measurable results. You can learn more about Allyn Cutts at http://www.AllynCutts.com and you can call 610.437.4106 between 10 AM and 4 PM Eastern Time Tuesdays and Thursdays. Related
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