Tuesday, 17 April 2012

The Five Forces of Competition

" We would rather own a great business at a fair price than bad a business at a great price" - Warren Buffet
These words have always been an issue for me. After all, it seems that we spend so much time worrying about discount rates, analysts' projections ,and discounted cash flow valuations. Who has time to try and go through the very hard, time-consuming task of not just analyzing the financial statements but the entire business structure as well?
Unfortunately we are never really taught how to evaluate a business. After all, long-term competitive advantage doesn't quite have the same appeal as easy-to-package ratios like a P/E ratio or book value. Yet for those of us who invest in the market, analyzing this is perhaps one of the most important and left-out steps in buying a share in a company.  Sure the price you pay is important but in the end the sad truth is that no one knows what any one company is going to earn in the future.  So how do we figure out if a company has the prospects we are looking for without an MBA? Michael Porter of Harvard University and author of Competitive Advantage developed the best method I know of. It is called the 5 forces of competition and it tells us in a nutshell the 5 things we must determine when evaluating a business's profitability in the future. These are as follows.

1. Threat of entry
This is how easy it is for a firm to enter the industry that your company is in. This is important because any industry worth looking at should earn above average returns. Those returns ultimately attract competitors who want to earn those high returns as well. However, when too many competitors join the fray it eventually drives prices and returns down and makes the industry unattractive. Usually companies that can protect themselves (also known as having a moat around their business) are either business that require high investment to enter (like Aerospace or Oil), have important brands (like Coke), have high switching to change (like Microsoft) or have a patent barring competitors (like drugs)

2. Bargaining power of suppliers

Companies who have only a few suppliers can't bargain with them or play one off another for better prices. Thisleads to higher priced inputs and dilutes returns (like airlines).

3. Bargaining power of buyers

This is affected by how big your customers are and how much revenue they constitute as well as other things. For instance Wal-Mart has a lot of power with suppliers because it buys so much of their inventory and is thus a large percent of those companies revenues. It is no surprise then that these companies have lived and died with Wal-Mart's orders and would do anything to protect their business with them.

4. Availability of substitutes 

This is how easily people can find something else if you were to raise prices or if they somehow found your offering unfavorable. For instance, oil has no substitute to date. People either pay the price or don't drive. Compare this with designer clothes, where if the price goes up you can always buy low priced jeans instead. For those of us who are economics students, this is also called elasticity of demand.

5. Competitive rivalry

This is how competitive an industry is. For instance, if there are lots of companies selling essentially the same products there will always end up being a price war which will severely hurt the company' profits. The wireless companies have had this problem for years and fierce competition has made it tough for them to make a profit.

Now let's take a look at an example of how we can use this when analyzing the cable industry.


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