Understanding finance

Porter's Five Forces

Sam Statham, Research Assistant

It is hard not to feel slightly inadequate when reading about Michael Porter. Not only does he have a PhD from Harvard University, authored 18 books and is a six-time winner of the McKinsey Award for the best Harvard Business Review, but it turns out he is also a very keen sportsman and, had the wind-blown in a different direction, could have been a professional golfer.

The first of his McKinsey Awards was for "How Competitive Forces Shape Strategy" in which he highlights his five forces that identify how competitive and potentially attractive an industry is. Once analysis is conducted through the lens of the five forces, a business or an investor can focus on avoiding a situation where they are operating in a hostile environment or look to improve their position.

Force one and two are Supplier and Buyer Power. For suppliers, they can pressurise a business by raising their prices, lowering quality or reducing the availability of products. On the flip side buyers can push prices down, demand higher quality products or better customer service.

The third is the Threat of Substitution. If close substitute products exist, the likelihood of customers switching to alternatives in response to hiked prices increases. This reduces both the power of suppliers and the overall attractiveness of the market.

The fourth is the Threat of New Entry. Economic theory says a profitable market attracts new entrants, which as a result, reduces profitability. However, that is dependent on the barriers to entry, a business with strong brand loyalty, large capital requirements or economies of scale will be more resilient. A prime example of where economic theory meets the constraints of reality.

Finally, Industry Rivalry. In a highly competitive industry that’s fraught with price wars and promotional activity, costs increase and profitability diminishes.

It is important to examine both the current state of an industry and look into the future; if it’s attractive now that’s not to say it won’t change going forward.

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