Porter's Five Forces Analysis Definition
Porter’s Five Forces analysis is a framework to analyze the characteristics that affect competition within an industry. The analysis is best suited to study industry competition, but it can also help companies establish a business strategy. The less competitive an industry, the higher the potential to earn profits in that industry. Inversely, competitive industries work to drive down the potential for any business to make money.
The Five Forces model has three components that measure competition. External forces include: intensity of existing rivalry, threat of substitutes, and threat of new competitors. These forces are out of the control of the subject company, whereas, internal forces (bargaining power of suppliers and bargaining power of customers) are a direct result of the subject company’s decisions. The combination of these forces determines the level of competition that will affect the subject company.
The Five Components of Porter’s Five Forces Model are Listed Below:
- Intensity of existing rivalry (external): This is usually the most important determination of competitive forces. It gauges the level of competition between rivals that compete directly on prices and quality. Examples include: low exit barriers and low storage cots.
- Threat of substitutes (external): The availability of substitute products increases the chances that a business will lose customers; thus, substitution risk lowers profitability. Examples include: limited number of substitutes and high cost of switching to substitutes.
- Threat of new competitors (external): New competitors are often drawn to an industry because of the opportunity to make profits. When new competitors enter markets, they become rivals to existing market participants, which tends to lower the profitability of all market participants. An increase in competition lowers profits with all else staying the same. Examples of the external component include: patents limiting new competition and industry requires economies of scale.
- Bargaining power of suppliers (internal): The more pressure suppliers can exert on a company, the more bargaining power they have over that company. Bargaining power generally increases profitability for the party that exerts it. Examples that affect bargaining power to suppliers include: volume is critical to suppliers and there are diverse distribution channels.
- Bargaining power of customers (internal): The more pressure customers can exert on a company, the more bargaining power they have over that company. Bargaining power generally increases profitability for the party that exerts it. Example that affect bargaining power to customers include: limited buyer choice and large number of customers.
How Does Porter's Five Forces Analysis Improve Stock Research?
WikiWealth uses the five forces template to improve the qualitative analysis for each investment research report. Generally, the more competitive an industry, less profits are available to each participant. Therefore, investors should look for industries with low competition. The five forces analysis helps to model the characteristics that affect competition.