Porter's Five Forces and economic moats

What do the five forces tell an analyst?

They tell you how profitable an industry can be. Porter’s Five Forces is a framework for the structure of an industry. If some or all of the five forces are intense, the industry’s return on capital is unlikely to beat its cost of capital, much like the perfectly competitive market in Economics where price falls to marginal cost. Mild forces leave room for a highly profitable industry.

The five are the threat of new entrants, the threat of substitutes, the bargaining power of customers, the bargaining power of suppliers, and rivalry among existing competitors.

An analyst uses them in three ways. They explain the profitability the survey measured. They suggest scenarios for how the structure may change. And for a young industry with little data or no profits yet, they point to how likely profits are, when they might come and how large they could be.

Industry structureintense forces: returns near the cost of capital

• Threat of new entrants Memorize weak when moats are wide
  • Regulation and licensing can forbid or deter entry
  • Patents temporary: until expiry
  • Moat sources lasting: see the moat tree
• Threat of substitutes Memorize same need, often a lower price
  • From other industries easy to miss
• Bargaining power of suppliers Memorize strong suppliers push input costs up
  • Concentrated suppliers
  • Unique or tailored inputs
  • High switching costs
  • Skilled, licensed or organized labor
• Bargaining power of customers Memorize strong customers push selling prices down
  • Commodity products
  • Very low switching costs
  • Few, large buyers
• Rivalry among existing competitors Memorize shaped by the other four forces
  • Price competition
  • Product differentiation
  • Relative size and share changes
  • Industry growth and profitability

What is an economic moat?

Memorize

An economic moat is a long-lasting competitive advantage, named after the water-filled ditch around a castle. The wider the moat, the longer a firm can keep earning more than its cost of capital.

A moat can protect every firm in an industry with few members, such as an oligopoly. It can also protect just one or two firms in a crowded industry whose returns as a whole fall short of the cost of capital.

A widely used commercial moat rating, Morningstar’s, scores five sources: intangible assets, switching costs, the network effect, cost advantages and efficient scale. They map neatly onto the threat of new entrants, because each one keeps newcomers out.

Economic moatthe wider, the longer excess returns last

• Intangible assets Memorize patents, loyal brands
• Switching costs Memorize money, time, risk of changing
• Network effect Memorize more users, more value
• Cost advantage Memorize technology, scale, economies of scope
• Efficient scale Memorize room for only a few producers

For a valuation, the width of the moat is a question about time: how many years can returns stay above the cost of capital before competition pulls them down? That judgment shapes the margin and growth assumptions and how long they last in the model.

How strong is the threat of new entrants?

The threat of new entrants is weak when getting in is hard and expensive, and strong when newcomers can win customers quickly. Start from the survey: market share trends show how many firms entered and how much share they took.

Incumbents respond by buying promising start-ups before they grow, or by partnering with them, for example through a joint venture, to get their technology. Some entrants remain a lasting threat however incumbents respond.

Government matters too. Regulation can forbid entry, as when one regulated utility holds the right to supply water or power in a region, or deter it, when the cost of complying is affordable only for large firms. Subsidies for domestic firms and restrictive licensing also keep entrants out.

Patents are temporary. Analysts treat patents as a temporary barrier : a patent gives its owner the exclusive right to sell a product or technology, but only until it expires. Analysts must value that advantage over the remaining protection period, not forever: when the patent ends, cheaper copies arrive and revenue can fall sharply. A license granted for a fixed term works the same way.

Lasting barriers are the moat sources.

• Intangible assets : patents and also brands customers stay loyal to, common in luxury goods and food and drink. A perfume house can charge several times the price of a near-identical scent.
• Switching costs : what a customer gives up to change provider: money, time, the risk of an untested supplier, the upgrades it expects from the current one. Payroll software wired into a firm’s accounting and human resources systems takes months and consultants to replace; a food-delivery app costs nothing to swap.
• Network effect : a product is worth more to each user as more households or businesses use it, a demand-side economy of scale that a newcomer cannot match. It pays only if the owner can earn money from the network, through fees or advertising, and that usually grows with use. The Corporate Issuers lesson on network effects and platform business models goes deeper.
• Cost advantage : serving customers at lower cost than an entrant could, usually together with proprietary technology, brand loyalty or scale.
  • Economies of scope are one kind: producing two or more goods or services together costs less than producing each separately, as when one cable carries TV, internet and phone.
• Efficient scale : a market with mature, inelastic demand for a commodity-like product and high entry costs, where one more producer would push everyone’s returns below the cost of capital, so no one enters. A remote region’s cement market that fills two plants is our example.

Exam tip Patent or license: temporary. Proprietary technology, brands, switching costs, networks, scale: lasting for as long as no one can copy them.

How strong is the threat of substitutes?

The threat of substitutes rises when another product meets the same or a similar need, especially at a lower price. The substitute often comes from a different industry. Timber and steel frames can replace some concrete in buildings, e-books replace some printed books, and an electric scooter can replace a short taxi ride. Home-fitness apps compete with gyms although no gym counts them as rivals.

How strong are suppliers and customers?

The bargaining power of suppliers rises with how concentrated the suppliers are, how unique or tailored their inputs are, and how costly it is to switch. Licensing a key technology or piece of intellectual property (IP) gives the licensor the same kind of power, as with rights to broadcast live sport. Energy is a large, volatile input for cement, so energy suppliers matter.

Labor is a supplier too. Workers who are highly skilled, need a license or are well organized, for example in a strong union, can push wages up, and a strike can stop production.

Supplier power is lowest when many small firms sell standard inputs that are easy to replace, as for restaurants or simple manufacturing. Then the industry’s big buyers can dictate price, quality, delivery times and payment terms.

The bargaining power of customers is high when the product is a commodity or switching costs are close to zero. Firms fight back with price cuts, differentiation, bundles and loyalty rewards such as discounts and points. A concentrated customer base, a few large buyers, raises customer power further. A few large construction groups buying most of a region’s cement are strong customers.

Strong customers push selling prices down. Strong suppliers push input costs up. Either reduces the industry’s profit.

When does vertical integration help?

Use it

When suppliers or customers are powerful. Vertical integration is expanding into an earlier or later stage of the chain that delivers a product to end users.

• Upstream or backward integration : taking control of suppliers or raw materials, through exclusive supply agreements, joint ventures or outright ownership. The trade-off is less dependence on scarce inputs and powerful suppliers, in exchange for a large upfront investment and less flexibility.
• Downstream integration : cutting out distributors, retailers and other intermediaries that deal with end users, to keep more of the value chain behind the final price, improve efficiency or offer customers one integrated service.

A chocolate maker buying a cocoa-processing plant is upstream. A sportswear brand selling through its own online store instead of department stores is downstream.

Vertical integrationanswers supplier or customer power

• Upstream (backward) Use it control suppliers: agreements, joint ventures, ownership
• Downstream Use it cut out intermediaries, keep more of the value chain

Exam tip Vertical integration brings work in-house: it is the opposite of outsourcing. It answers supplier or customer power, not the threat of substitutes.

How intense is the rivalry?

Judge rivalry among existing competitors from price competition, product differentiation, the relative size of the major competitors and how their shares change, and the industry’s growth and profitability.

No rule says which factor matters most. A good analysis sets out scenarios in which one or more factors dominate, for example a price war if demand falls. When leaving is costly, weak firms stay and keep cutting prices in downturns: these are barriers to exit . Outside events such as a recession or volatile fuel prices change which force matters most, which the next lesson takes up.

Five Forces explain how profitable an industry is. What drives its growth comes from outside, and the next lesson’s PESTLE framework covers it.

Go deeper Network effects as an entry barrier

Take a card payment network. A shop accepts a card only if many shoppers carry it, and shoppers carry the card that many shops accept. A new network must solve both sides at once, so even a better or cheaper product struggles to reach the scale at which it becomes useful. The barrier is not capital alone but the value that arrives only with users. The owner gains only if it can earn money from the network, through fees or advertising.

Go deeper Why fixed costs and perishable capacity intensify rivalry

When most costs are fixed and capacity cannot be stored (an empty airline seat or an idle cement kiln earns nothing), any sale at a price above the variable cost adds to profit. Every producer is tempted to cut price to fill capacity, and rivals have to follow. If products are also identical, price is the only lever left, and the whole industry’s margin drops. Barriers to exit make it worse: weak firms stay and keep cutting prices in downturns.

Go deeper A rule can move two forces at once

Suppose a new rule requires every gym to install costly air-filtration systems but does not cover home-fitness apps. It raises the cost of opening a gym, which lowers the threat of new gym entrants, and it makes the apps relatively cheaper, which raises the threat of substitutes. Effects on rivalry can therefore go both ways. Ask which force each part of a change touches, one by one.