If you’ve ever listened to Warren Buffett talk about investing, you’ve heard him mention the idea of a company’s moat. The moat is a simple way of describing a company's competitive advantages. Company's with a strong competitive advantage have large moats, and therefore higher profit margins. And investors should always be concerned with profit margins.
This article looks at a methodology called the Porter’s Five Forces Analysis. In his book Competitive Strategy, Harvard professor Michael Porter describes five forces affecting the profitability of companies. These are the five forces he noted:
1. Intensity of rivalry amongst existing competitors
2. Threat of entry by new competitors
3. Pressure from substitute products
4. Bargaining power of buyers (customers)
5. Bargaining power of suppliers
These five forces, taken together, give us insight into a company's competitive position, and its profitability.
Rivals
Rivals are competitors within an industry. Rivalry in the industry can be weak, with few competitors that don’t compete very aggressively. Or it can be intense, with many competitors fighting in a cut-throat environment.
Factors affecting the intensity of rivalry are:
* Number of firms – more firms will lead to increased competition.
* Fixed costs – with high fixed costs as a percentage of total cost, companies must sell more products to cover those costs, increasing market competition.
* Product differentiation – Products that are relatively the same will compete based on price. Brand identification can reduce rivalry.
New Entrants
One of ...