Porter's five forces: how competition shapes prices and costs

What are the five forces?

Porter’s five forces is a framework for judging how much of an industry’s value its companies keep. Each force is a source of pressure on prices or costs. Analysts use it to decide whether a forecast should show strong or weak pricing, and high or low margins.

Industry profit potentialstrong forces squeeze margins and ROIC; weak forces mean pricing power

• Threat of substitutes Memorize caps the price
  • Raises it Use it close alternatives, low switching costs
  • Lowers it Use it brand loyalty, high switching costs, no close alternative
• Rivalry Memorize price cuts to win or hold volume
  • Raises it Use it many similar rivals, high fixed costs, excess capacity, slow growth
  • Lowers it Use it few rivals (consolidated market), differentiated products, growing demand
• Bargaining power of suppliers Memorize pushes up input costs
  • Raises it Use it few suppliers, unique inputs, costly to switch
  • Lowers it Use it many suppliers, commodity inputs, long-term contracts
• Bargaining power of buyers Memorize pushes down prices or stretches payment terms
  • Raises it Use it concentrated buyers, standardized product, easy to switch
  • Lowers it Use it many small buyers, specialized or branded product
• Threat of new entrants Memorize high margins attract entry and get competed away
  • Raises it Use it low capital needs, no brand or scale advantage, light regulation
  • Lowers it Use it barriers: capital needs, brands, regulation, scale, locked-in supply

• The threat of substitutes is the risk that customers switch to a different kind of product that meets the same need. The closer the alternative and the lower the cost of switching, the harder it is to raise prices.
• Rivalry is the intensity of competition among existing firms. It is high with many similar competitors, high fixed costs, slow growth and excess capacity, because firms cut prices to fill plants.
• The bargaining power of suppliers is the ability of input providers to raise their prices or limit supply. It is high with few suppliers or unique inputs.
• The bargaining power of buyers is the ability of customers to push prices down or demand better terms. It is high when buyers are concentrated or the product is standardized.
• The threat of new entrants is how easily newcomers can compete away profits. Barriers to entry such as large capital needs, strong brands, regulation and scale keep the threat low.

A strong force hurts the company. When the forces are weak, the company has pricing power : it can raise prices and pass on higher input costs without losing much volume.

Government is not a sixth force. Regulation and taxes matter because of how they change the five forces. A tax on the whole industry, for example, raises costs for every rival at once.

How do the forces feed into a forecast?

Strong forces point to flat prices and squeezed margins. Weak forces point to price/mix gains and the ability to protect margins when costs rise.

Two industries show the contrast.

• Premium aged spirits. Supply is limited by regulation and by the years of stock needed to age the product. Brand loyalty is high, and customers rarely switch to another drink. Barriers to entry are high. Most of the forces are weak, so a forecast should include price/mix gains and the ability to pass on cost increases.
• A mass-market brewer selling through a few supermarket chains. The product is standard, the buyers are large and concentrated, and rivals have high fixed costs and are losing volume. Buyer power and rivalry are strong. The forecast should show flat prices, a margin squeeze when input costs rise, and a risk of price wars if volumes fall.

The same company can face different forces in different countries. It can lead a concentrated market at home, where a handful of rivals compete on brands rather than price, and be a small player abroad in a crowded market where large retailers set the terms. Its margins in the two places can be far apart, so for such a company the forecast is best built country by country.

Forces also drive individual lines. A rise in selling and marketing costs can reflect rivalry and the threat of substitutes, as the company spends to build brand loyalty. Pressure from large retail buyers can be met by lower prices (lower margin) or by longer payment terms (more receivables, so more invested capital). Either way, buyer power costs the company something.

Go deeper Paying for buyer power with credit terms

Take a company with sales of 2,000, an operating margin of 14% and invested capital of 1,000. Operating profit is 280, a pre-tax return of 28%.

• Scenario A, price pressure: margin falls to 12%. Profit is 240 on the same 1,000, a return of 24.0%.
• Scenario B, longer payment terms: margin holds at 14%, but customers pay about 46 days later, so receivables rise by 250 (2,000 × 45.6 ÷ 365) and invested capital reaches 1,250. Profit is 280 on 1,250, a return of 22.4%.

Scenario B keeps the better margin and still earns the lower return. ROIC catches the cost of the concession that the margin hides.

How do you calculate ROIC?

ROIC is net operating profit after tax (NOPAT) divided by the net capital tied up in operations. It is the number analysts use to judge whether a company has an advantage that lasts. Return on invested capital uses operating assets less operating liabilities as the base: the capital that investors have to fund.

$$ROIC = \frac{EBIT\,(1 - t)}{\text{operating assets} - \text{operating liabilities}}$$

A high ROIC that persists year after year often signals a competitive advantage , in other words weak forces. One good year does not. Margins alone do not show an advantage either, because a thin-margin business with fast-turning capital can earn a high ROIC and a high-margin business with heavy assets can earn a low one.

ROIC questions can also run backward, from a target return to the profit or assets needed.

Exam tip When comparing companies in countries with very different tax systems, a pre-tax measure such as operating margin is the cleaner comparison. ROIC after tax mixes in the tax regime.

Go deeper Where five forces fit in the wider equity work

The forces are one input to a forecast, not a formula. They tell you which way to lean: weak forces support margins and ROIC above peers and growth at least in line with the industry, while strong forces argue the other way. Turning that lean into a number for price/mix or margin is a judgment, best checked against what peers have actually earned. The industry analysis module in the equity topic covers the forces and the industry life cycle in much more depth.