Do you look at the macro picture before investing in a company?
Let me tell you, it’s very important to conduct industry analysis when you are planning to invest in a company.
There is a concept of a top-down approach where you need to start with economic analysis, followed by industry analysis and lastly company analysis.
We should conduct industry analysis using Michael Porter’s five force model.
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.
Also Read: Michael Porter’s Five Force Model
Michael Porter said-
A strategy delineates a territory in which a company seeks to be unique
Industry analysis is an assessment tool which is designed to provide the business with the idea regarding the complexity of a particular industry.
It involves reviewing economic, market and political scenario which influences the development of an industry.
Economic overview involves examination of the industry’s business cycle while political overview helps in understanding the amount of government regulation and taxation present in the business industry.
It is very important to understand what leads to sustainable value creation in relation to a company.
One of the important factors of sustainable value creation is the industry a company operates in.
For instance, you would be more interested investing in a pharma or a FMCG company and you might not be willing to invest in a company in a sugar industry.
Hence, the best way to analyze whether a company can generate value sustainably over a longer term is to analyze the industry in which the company is operating.
One of the simple but useful approaches would be to answer a set of questions-
1. Is this an appropriate industry to invest in?
2. Are there any quality players even if the industry is an average?
3. What are the challenges and growth drivers for the industry?
4. Who are the dominant players and why are they dominant?
5. What are the factors which will shape an industry’s future?
Porter believes that the combined strength of these five forces shapes industry’s potential for value creation. The following are the factors discussed in detail-
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 product and at a cheaper price.
The more is the buyer concentration, better is the impact they can create.
Buyers increase the level of competition within an industry by bargaining for better services and to reduce prices.
In order to assess the power of buyer, here are the conditions which 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 supplier for a product
d. Product is a necessity to the 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 firms profitability.
The availability of a substitution 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 which new competitors would pose to the existing competitors in the industry.
If the barriers to entry are low, higher 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.
Higher levels 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 one firm exerts pressure on another firm within the industry and restrict each other’s profitability.
If the level of competition is intense, competitors may try to eat away the profit and market share from one another.
Highly competitive industries generally earn low return because the cost of competition is high.
Warren Buffett angle:
Mr Buffett likes to invest in industries that have a moat around them. In other words, they have a strong position that competitors cannot penetrate easily. So using Porter’s five forces helps you in understanding the competitive position of a company or an industry and allows you to invest like Warren Buffett.
To know about Porter’s Five Force Model you can watch the video:
Let’s assume that you have decided to switch your career and want to open your own restaurant.
You are a great foodie who loves experimenting with food and have great ideas to serve healthy and innovative food to society at large and at the same time, you wanted to be your own boss.
Enroll for NSE Academy Certified Equity Research Analysis course to understand industry analysis in-depth.
So let’s understand, how to analyse the above example using Porter’s five force model.
Porter’s five force example: Opening a restaurant
Threat from competition
- Large number of competitors
- Low customer loyalty
- Low switching cost
Threat of new entry
- Entering into the industry is inexpensive
- Trained manpower is easily available or can be trained
- No real barriers to entry
- Economies of scale for large manufacturers
- Large number of suppliers
- No real supplier power
- Low cost of substituting
- Large number of buyers
- Low price sensitivity
- High ability to substitute
- Low cost of substituting
Threat from Substitution
- Low cost of substitution
- Large number of substitutes
Porter’s 5 force is an important tool for industry analysis and to assess its potential for profitability.
Simply by identifying the strength and direction of each force, you can analyse company’s strength within the industry and its ability to generate sustained profit in the future.
Take care and keep learning!!!