Porter’s Five Forces model is a widely acknowledged and respected framework for evaluating an industry’s attractiveness to investors. Michael Porter believes it can be applied to any industry.
According to this theory, there are five forces: the threat of new entrants, the bargaining power of suppliers and buyers, the threat of substitutes, and competitive rivalry among existing firms. The strength of the first four forces contributes to the intensity of competitive rivalry.
When any of these forces gets stronger, rivalry tends to intensify, making the industry less profitable. This is why businesses aim to raise barriers to entry, work with buyers and suppliers who have limited bargaining power, and reduce the threat of substitutes.
Every business comprises tangible and intangible components that determine its future growth potential and profitability. Tangible aspects can be assessed using tools like stock screeners, whereas intangible elements — being subjective — depend heavily on an analyst’s experience and comprehensive understanding of markets.
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The threat of new entrants
New entrants to an industry can drive down existing product prices and simultaneously raise production costs.
Michael Porter points out that competitors from outside the industry can leverage their investments and “shake up competition” like “Microsoft did when it began to offer internet browsers.”
Some industries are easier to enter while others have much higher entry barriers. Moreover, expected retaliation from established players can significantly influence an entrepreneur’s decision to enter a new business or pursue a completely different industry.
The bargaining power of suppliers
Suppliers can sometimes pose a greater threat than competitors, especially when they control essential resources, including labor.
“Pilots’ unions, for example, exercise considerable supplier power over airlines partly because there is no good alternative to a well-trained pilot in the cockpit.”
Some suppliers hold exclusive rights, such as patents, to specific products, like pharmaceutical companies with patented drugs, increasing dependency on them. Moreover, suppliers may integrate forward into the industry, especially if they see that buyers earn significantly higher profits.
The bargaining power of buyers
Buyers can also gain extreme power over suppliers, especially when there are few in number or represent a substantial portion of a supplier’s revenue.
This dynamic is common in markets with limited customers. For example, water has a broader customer base than copper. In such cases, buyers can set terms and push prices down.
Another scenario involves customers with high expectations, such as Apple devices and Tesla cars. Consumers are highly aware of available alternatives, and manufacturers are expected to offer top-notch products and services. Even a small failure can lead to a prolonged decline in revenue.
Tesla provides a real-world example of this sensitivity. When customer expectations are not met — whether due to software issues, delayed deliveries, or unmet innovation promises — investor sentiment can shift rapidly, which is often reflected in Tesla stock price, which has shown notable volatility in response to product news, earnings reports, and customer feedback.
The threat of substitutes
“Substitutes are always present, but they are easy to overlook because they may appear to be very different from the industry’s product.”
Although they may not initially seem like direct competitors, they can gradually replace each other. For example, “videoconferencing is a substitute for travel; plastic is a substitute for aluminum,” and so on.
Sometimes, especially in situations when buyers haven’t decided on a specific product (e.g., gift shopping), a wide variety of goods can be seen as interchangeable.
Rivalry among existing competitors
As mentioned before, the intensity of rivalry is influenced by the other four forces. The stronger any one of these four, the more intense the rivalry, and the less profitable the industry tends to be. Under high competitive pressure, products and services may also become less satisfying to customers.
Rivalry depends on both intensity and the basis of competition.
High-intensity rivalry results in a company’s earnings, higher production costs, shorter product lifecycle, and more. In short, every business aspires to become a monopolist, so fierce competition is often seen as detrimental to profitability.
Rivalry is especially intense when:
- Many competitors are similar in size and capacity.
- Industry growth is slow, leading to fierce battles for market share.
- Exit barriers are high, causing even unprofitable companies to stay in the market.
- Businesses compete for non-economic reasons, such as prestige or brand image.
Price-based rivalry occurs when:
- Competitors offer similar products
- “Fixed costs are high and marginal costs are low”
- “Capacity must be expanded in large increments to be efficient”
- “The product is perishable”
Non-price competition, such as based on durability, design, or delivery speed, is less likely to reduce business profitability, as customers are often willing to pay for added value.
While intense rivalry typically benefits consumers through better and cheaper products, it can also benefit businesses, especially when each competitor caters to a distinct market segment with tailored offerings.