Conducting industry analysis becomes very relevant, especially when you are planning to invest in a company.
According to a top-down approach, you need to start with an economic analysis, followed by industry analysis, and finally company analysis.
Michael Porter’s five forces model is an important tool in conducting an industry analysis.
Porter is a Harvard Professor renowned for his work in developing a specialized industry analysis model.
This is an appropriate way to assess the structure of an industry.
Michael Porter believes that the combined strength of these five forces shapes the industry’s potential for value creation.
Here is a list of 5 factors that determine the competitive strength of an industry
1. Bargaining power of Buyers
It refers to the bargaining strength of the buyer, which they can exert on businesses to attain better customer service, good quality products, and lower prices.
The more the buyer concentration, the better the impact they can create.
Buyers increase the level of competition within an industry by bargaining for better services and reducing prices.
In order to assess the power of the buyer, here are the conditions that you need to look into-
a. Concentration of buyer
b. Switching cost
c. Sensitivity of customers
d. Volume of transactions
2. Bargaining power of Suppliers
It refers to the pressure exerted by the supplier on the businesses by raising prices, lowering product availability and reducing quality.
A strong supplier can make an industry more competitive and decrease profit potential for the buyer.
The factors leading to supplier power are as follows:-
a. Presence of no substitute
b. Higher switching cost
c. Lesser number of suppliers for a product
d. A product is a necessity for consumers.
3. Threat of Substitutes
A substitute product is a product of another industry that offers similar benefits to the consumer as the product produced by the firms within the industry.
Say if the price of coffee rises drastically, a coffee drinker may switch over to another beverage like tea.
The threat from a substitute in an industry affects the competitive environment for the firms in that industry and influences the firm’s profitability.
The availability of a substitute threat affects the profitability of an industry because consumers can choose to purchase the substitute instead of the industry’s product.
4. Threat of New Entrants
It refers to the threat that new competitors would pose to the existing competitors in the industry.
If the barriers to entry are low, the chances of new entrants in the market.
The threat from new entrants affects the level of competition for the existing competitors and also influences the ability of existing firms to achieve profitability.
The higher the level of competition, would lead to decrease in market share and profitability of existing competitors.
The factors that may affect the threat of new entrants are-
a. Government restriction
b. Higher switching cost
c. Higher fixed cost
d. Existing loyalty to major brands
5. Rivalry among Existing Firms
It refers to the extent to which one firm exerts pressure on another firm within the industry and restricts each other’s profitability.
If the level of competition is intense, competitors may try to eat away at the profit and market share.
Highly competitive industries generally earn low returns because the cost of competition is high.
Bottomline:
So the next time you are planning to invest in a company, conduct Porter’s five forces model analysis to have a better understanding of the industry.
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