Force 3: Threat from Substitute Products
The availability of multiple substitute products can decrease the profitability of an industry. This is because customers have more choice available to them and can switch to other products easily if the products of an industry are priced too highly. However, when a product is very unique in the market and there are few, if any, substitutes, this will mean that there are high switching costs involved for customers and that the company or industry producing the product can raise prices to earn abnormal profits.
One example of an industry with no substitutes is the water industry. There is no substitute for water, and utilities companies, if operating in a monopoly, have the potential to raise prices upwards. The lack of substitutes means that people do not have the choice to switch to other products, and water companies often exhibit strong pricing power. However, because there is a need for the provision of this basic resource to society at large, governments often regulate that water companies are not allowed to raise prices above a certain point, to prevent an abuse of industry power at the expense of society.
On the other hand, the t-shirt industry faces many substitutes. If a customer is looking to buy a new t-shirt, he will be very much spoilt for choice. He has at his disposal the option to purchase collared tees, short sleeved shirts, tank tops, or basically any other garment that clothes his upper body. This availability of multiple substitutes greatly diminishes the pricing power of any t-shirt producer, who often has to provide value in other ways, in the form of designs or brands.
In general, an industry that has few substitutes or potential substitutes is an attractive industry to operate in.
Force 4: Bargaining Power of Suppliers
The third force that determines the profitability of an industry is the bargaining power of the suppliers of inputs into the industry. The more consolidated the suppliers are, the more bargaining power they will have, and the higher the prices the suppliers will be able to charge to companies in the industry. The higher the prices of inputs, the higher the costs for the industry, and the less profitable the industry will be.
An example where a supplier has very strong bargaining power is the personal computer industry. Two of the key suppliers, Intel and Microsoft, dominate their industry and are able to exert strong bargaining power on their customers to push up the prices of their inputs: computer chips and operating system software. Because the PC assemblers are relatively fragmented, they do not collude to exert as much counter-bargaining power as they possibly could.
On the other hand, a global giant like Wal-Mart faces fragmented suppliers and thus is able to exert strong bargaining power on the products it needs to stock its shelves. This allows it to keep costs low and pass these savings on to its customers.
It should thus be apparent that, all other things equal, a favourable industry to be in is one which has suppliers that have relatively weak bargaining power.
Force 5: Bargaining Power of Customers
Just as strong suppliers can eat into an industry’s profits, so can strong customers. Conversely, an industry can exert pricing power against the weak bargaining power of numerous small customers. In this way, the bargaining power of customers relative to suppliers helps to determine the level of profitability of an industry.
A regional newspaper with a monopoly will be able to raise prices relatively easily because its customers are many and fragmented. It will also be able to charge a premium for advertising because it is the only platform available to advertisers to disseminate their messages. The customers of the newspaper have weak bargaining power, and the newspaper is able to profit accordingly.
On the other hand, a regional broadcast station with a monopoly will also be a strong buyer when it comes to negotiating for programming airtime. If the television producers are a fragmented bunch, their industry will have to suffer a loss of profits due to the fact that the customer of their products is in a very strong negotiating position because it is the only customer for the product.
Once again, the weaker the bargaining power of an industry’s customers, the more attractive the industry is.
Before investing in a company, it is necessary to understand the competitive environment it is operating in. A company in an industry that scores poorly on the five forces is likely to be vulnerable to competition and have its profits competed away. Such a company is likely to make an unattractive investment.
The astute investor is always on the look out for a company that is operating in a favourable competitive environment, or which has the ability to shape and mould the competitive dynamics of its industry so that the competitive forces are relatively benign. Such companies stand a much higher chance of not only maintaining their profits, but growing them far into the future.
For an example of an in-depth Five Forces Analysis of a company, peruse Blackmores - A Strategic Analysis (Part 2)