A business has to understand the dynamics of its industries and markets in order to compete effectively in the marketplace. Porter identifies five forces that dictate the rules of competition in each industry. These forces determine industry profitability because they influence the prices, costs, and required investment of firms in an industry.
The elements of a thorough industry analysis include the following:
Barriers to Entry
In theory, any firm should be able to enter and exit a market, and if free entry and exit exists, then profits always should be nominal. In reality, however, industries possess characteristics that protect the high profit levels of firms in the market and inhibit additional rivals from entering the market. These are barriers to entry. They are advantages that incumbents have relative to new entrants.
The threat of entry in an industry depends on the height of entry barriers that are present. If entry barriers are low, the threat of entry is high and industry profitability is moderated.
Generally, high barriers to entry can lead to better pricing and less competitive industry conditions. However, barriers to entry are not barriers to success, and high barriers to entry do not necessarily lead to good pricing power and attractive industry economics. Barriers to entry can also change over time.
Industry concentration is often, although not always, a sign that an industry may have pricing power and rational competition. Industry fragmentation is a much stronger signal, however, that the industry is competitive and pricing power is limited.
Certainly there are important exceptions. There are industries that are concentrated with weak pricing power and there are also industries that are fragmented with strong pricing power. The level of industry concentration is just a guideline.
Tight capacity -> more pricing power
The analyst should think not only about current capacity conditions but also about future changes in capacity levels: how long does it take for supply and demand to reach equilibrium? Are the tight supply conditions sustainable?
In general it takes longer to shift physical capacity than to shift financial and human capital to new uses.
Market Share Stability
Stable market shares -> less competitive industries
Industry Life Cycle
The industry life cycle reflects the vitality of an industry over time. Each industry develops along a similar cyclical path that includes the following stages:
There are certainly limitations of industry life-cycle analysis. Demographics and changes in technology as well as political and regulatory environments all play a role in affecting the cash flow and risk prospects of different industries. Some stages may become longer or shorter than expected and some stages may even be skipped altogether. Another limitation is that not all companies in an industry have similar performances.
Price competition and thinking like a customer are important factors that are often overlooked when analyzing an industry. Whatever factors most influence customer purchasing decisions are also likely to be the focus of competitive rivalry in the industry. Broadly, industries for which price is a large factor in customer purchase decisions tend to be more competitive than industries in which customers value other attributes more highly.