Deals & Acquisitions
Mar 8, 2023
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This guide is designed to explain what Porter's Five Forces is and how it is used in the strategic analysis of a business. Here are some key takeaways about Porter's Five Forces:
Porter's Five Forces is a framework (or model) used around the world in order to better understand the competitive forces that shape an industry.
Porter's Five Forces gets it's name from the Harvard Business School professor Michael Porter, who first published it in 1980, hoping to give management teams a tool to better understand the risks and opportunities that businesses face and compete to win.
When we look at Porter's Five Forces in the context of an M&A deal, we're using it as a framework to understand the industry that the business is operating in.
Strategic analysis is qualitative in nature and used as a way to understand financial analysis, which is quantitative in nature. Many of the assumptions and drivers that we use in the financial models that drive M&A deals are based on our perception of the industry the company operates in.
Porter's Five Forces is a tool for helping M&A analysts make judgment calls about the validity of their assumptions. So, if we're assuming the business we want to buy can grow at 10 percent over the next few years, and we see that the industry itself is growing at 20 percent, we are more likely to believe our 10 percent growth rate is reasonably possible.
This sort of qualitative analysis is important in M&A deals because it helps to ground the financial models we use to make decisions in more objective reality.
Now that we understand what Porter's Five Forces is used for we can look at how this framework actually works. The framework uses five lenses to examine an industry.
These lenses are: barriers to entry, buyer's bargaining power, the threat of substitutes, supplier's bargaining power, and industry competition.
The infographic above serves to visually highlight these five forces.
Barriers to entry are potential roadblocks that might prevent new competition from entering the market or from gaining traction.
An example of a barrier to entry would be the large amounts of capital needed to enter some industries. In order to compete, new rivals would need to first raise that capital. Another example could be intellectual property. If an established business has intellectual property to build on, rivals that would need to develop their own IP from scratch are starting at a disadvantage.
Barriers to entry are unattractive to new competitors, because they represent challenges that must be overcome in order to compete in an industry. This serves to limit the number of new entrants that come to compete in the market.
To the established businesses that already operate in these industries, barriers to entry are seen as a competitive advantage and serve as protection from competition. Barriers to entry make M&A deals more attractive because buyers understand that they are buying a business with a degree of insulation from new competition. Warren Buffet is famous for his bias in investing in businesses that can boast some form of barrier to entry which he calls an "economic moat."
Buyer's bargaining power represents the leverage that buyers (consumers) have over the producers (businesses selling things to them).
Ultimately, when buyers have a large number of alternatives they gain bargaining power because it is relatively easy for them to switch to another seller. This, in turn reduces the businesses pricing power, which has a direct impact on margins.
This bargaining power is also conceptually relative to next of Porter's Five Forces, the threat of substitutes.
The threat of substitutes looks at how the alternative options that consumers may have will impact the business' ability to compete.
When there are a lot of potential substitutes, this tends to erode any pricing power the business might have had.
An example to illustrate this force is Apple's iPhone. While there are many competitive smart phone makers, most iPhone users would argue that there really aren't any viable substitutes for their iPhones. This is part of what lets Apple charge premium prices
Supplier bargaining power is an extremely important factor to examine in product-based businesses.
It's used to understand how difficult it is for the business to receive the components necessary to make their final product from a different supplier. If a business is wholly reliant on only a few suppliers than those suppliers have considerable bargaining power over that business.
When we look at supplier bargaining power, we're looking at how vulnerable a business is to a supplier's ability to raise their prices. High supplier bargaining power will put downward pressure on a business' profit margins.
Supplier concentration is often a big consideration for credit professionals (who lend money to companies) when they are trying to determine what to lend a business.
Finally, Porter's Five Forces looks at the role that rivalry and industry competition plays. This force looks at the number of other players in an industry, and their level of concentration.
In an industry with high concentration, we typically see fewer players that are larger in size. When we see this in an industry, it's obviously considered a good thing to be one of those larger players. Large companies benefit from economies of scale, which make it easier to compete, and harder for new entrants to maintain profitability as they grow.
In an industry with low concentration (fragmented) we tend to see many smaller competitors. Here there is often more room for a business to differentiate while maintaining pricing power.
So far we've focused this guide exclusively on Porter's Five Forces. This framework is a great tool for learning about an industry. In addition to Porter's Five Forces, it's also useful to look at the industry lifecycle stage.
This infographic is designed to help visualize the lifecycle stages of an industry. The four main stages of an industry lifecycle are launch, growth, maturity, and decline. However some models also include a shakeout stage, and a reinvention stage.
Regardless of the model you use, it's important to look at the industry the company you are evaluating operates in. Industry lifecycle stages are also very useful for perspective.
