Wednesday, July 22, 2009

May the force be with you

I remember Obi Wan Kenobi telling Luke Skywalker in Star Wars “ May the force be with you” and “ Use the Force Luke”.

It brings back memories of a era gone by and reminds me also of something that I read a long time back Michael Porters “ 5 Forces Model”. To be honest there is a certain amount of cynicism that one displays during one’s MBA days for stuff that one would call “ management gyan”.

But like the way I appreciate Asterix comics or Calvin & Hobbes differently from the way I enjoyed them maybe 10 years back, Porter’s 5 forces model provides a nice framework to analyse a industry.

Buffett talks about the moat principle where the business should have adequate competitive advantage. I believe Porters “5 Forces Model” meshes in nicely with what Buffet said and provides a starting framework for evaluating a company.

The Five Forces
The threat of substitute products
The existence of close substitute reduces the leverage that a company has to raise prices as it lead to customers switching to substitutes. Also there could be substitutes which could make the current product irrelevant. Technology products are a classic example of this.

The threat of the entry of new competition
Low entry barriers into a business will ensure that the arbitrage of supernormal profits will get wiped out as more and more competition enters the business.

The intensity of competitive rivalry
Higher competitive rivalry could lead to the race to the bottom in terms of pricing and profitability. Airlines industries is a classic example.

The bargaining power of customers
Classic example would be concentrated set of buyers. Or the risk of buyers backward integrating or switching to substitute products.

The bargaining power of suppliers
Again concentrated set of suppliers could easily squeeze margins and ensure that the business cannot earn supernormal profits.

Porters 5 Forces model is a good starting off point in evaluating the moat around the company. Of course there are other variables that can be added to the process.

Which brings us to the question “ Why do we need to evaluate a industry structure in analysing a company”? That is for the next post.

Till then “ May Porters 5 Forces be with you”.


Daniel M. Ryan said...

Those five forces do provide a way of measuring the strenth of what Warren Buffett calls a "moat."

Ninad Kunder said...

Hi Daniel

Yeah its a good starting off point in measuring the moat.



Nandy said...

Porters 5 forces is an industry analysis. Applying it for company analysis sounds interesting. More so to me as I has suggested this at work, in a meeting, creating a debate.

Ninad Kunder said...

Hi Nandhitha

It is important to understand the industry framework under which a company operates.

More often than the company is driven by the structural variables that influence the industry. Intend to write a follow up post on this.



Aseem Kapoor said...

Nice post Ninad, the key point we need to understand is to apply these concept to a real company needs lot of indepth study of the indusry. Some forces like "supplier power" may not be meaningful in case of indusries using metals as raw material but as we see in case of RNRL vs RIL its absolutely crucial.

Ninad Kunder said...

Hi Aseem

You are right that some variables might not be applicable to certain industries or that the effect of those variables may not be high.

I think a little understanding of the industry enables you to atleast understand how the industry is structured. You could look at indepth analysis of the industry when u use variables to create a DCF. But a basic analaysis will tell u the industry structure.

Also in industries using metals supplier power can become a variable if there is a consolidation in the industry leading to a certain amount of cartelisation. Oil is a classic example. In India there is always the complaint of cement companiess pushing up prices in sync.