Determining Industry Attractiveness
As a potential buyer of a business, one of the most critical factors that will determine profitability is the growth prospect of the target company’s industry. Regardless of whether a firm is operationally effective or not, in the long-run profits are largely determined by the marginal equilibrium revenue for the industry. For example, the average return on investment for companies in the airline industry is significantly lower than companies that operate within the pharmaceutical industry. The large discrepancy in the return on investment between the two industries is due to factors such as competitive landscape, barriers to entry, product differentiation, required capital expenditures and operational overhead among other factors. Therefore, it is important to perform thorough commercial due diligence with the help of a business broker, to assess industry attractiveness and the potential for high returns on investment.
In order to determine the attractiveness of an industry, it is important to work with business brokers to analyze the 5 forces of the industry, also known as Porter’s 5 forces: buyer power, supplier power, threat from substitutes, threat from competitors, and the threat of new entrants. The Porter’s Five Forces Analysis forces a deep dive into the macroeconomics driving an industry. Industries in which companies can enjoy a high degree of differentiation, allow opportunities for higher markups and thus, higher profitability. Hence, having a clear understanding of the competitive environment in an industry can help in determining the competitive intensity and profitability of an industry.
A five forces analysis is crucial in determining a business’ strategy since the essence of strategy creation is developing a method to deal with competition. Competition within an industry is made up of a combination of various forces that include buyers, suppliers, substitutes, rivals, and potential entrants. These forces work together to determine the ultimate profit potential of an industry. The higher the strength of these forces, in combination, the more balanced the returns are of an industry where no company receives earns spectacular returns on their investment. The wider the moat created by the combination of these five forces, the more attractive companies in the industry can be.
For example, industries such as tires, metal cans, and steel possess more competitive pressures due to low barriers to entry and the highly commoditized nature of their products and services. Therefore, these industries typically receive lower returns on investment. On the other hand, industries such as energy and infrastructure have lower competition as the high initial capital required creates a high barrier to entry. Similarly healthcare and pharmaceutical manufacturers secure patents to create barriers to entry, thereby eliminating competition. Through this process, pharmaceutical companies can mark up their prices and boost margins.
Power of Buyers
The power of buyers examines the power that consumers possess and its effect on pricing and quality, which has a large effect on industry profitability. If buyers have a lot of power, they can collectively drive down prices and lower industry profitability. The power of the buyers is determined by the buyers’ price sensitivity and bargaining strength. These factors generally are closely related to the number of available substitutes for a product in the market and the competition. Some factors which affect buyers’ price sensitivity are product differentiation across companies, the cost of the product, and buyers’ profitability. The bargaining strength of buyers is determined by the switching costs buyers face, alternative products, availability of information, the volume of purchases made by buyers, and the degree of concentration among buyers. Buyers have greater bargaining when there are a higher number of competitors within an industry; as there is a greater selection of competitors to choose from, it will be easier for buyers to switch, thus decreasing switching costs that the customer may face if they were to jump from purchasing from a specific business to another one within the same industry.
For example, buyer power is high in the food retail industry. Customers have easy access to price checking among a large variety of different grocery stores. Moreover, switching costs between different competitors within the food retail industry are negligible, and price-conscious consumers enjoy a high degree of sovereignty.
Power of Suppliers
The power of suppliers examines a supplier’s ability to control pricing. Similar to buyer power, supplier power has an inverse relationship with industry profitability as it has the potential to raise costs. The more power the supplier has, the higher the input costs for target industries. Supplier power is determined by product differentiation across suppliers, switching costs faced by buyers, information available to buyers, the volume of supply, the degree of concentration among suppliers, and substitute inputs. Supplier power also analyzes the amount of raw material and resource suppliers that exist within an industry; the more suppliers there are, the better the position businesses are in as they have greater amount of suppliers to choose from. Contrastingly, the fewer suppliers that exist, the greater the power that suppliers have on pricing.
For example, supplier power in the chip manufacturing industry is extremely high as one chip manufacturing company accounts for over fifty percent of the global chip supply. Consequently, the high dependence on this particular supplier due to bottlenecks in supply chain and the high degree of product differentiation, leading to a lack of available substitutes gives suppliers in this industry a high degree of power.
Threat of Substitutes
The force of threat of substitutes examines the ease of consumers switching for a business’ product or service to that of a competitor. The more products that exist that may be different but serve the same purpose as the original product, the higher the likelihood of customers switching to alternatives. Substitutes do not have to necessarily be similar to the original product and only be branded differently; substitutes can be products that serve the same purpose for the consumer as the original product. Substitutes can create a cap on the prices that buyers will pay and a floor on the prices that suppliers will require. Substitutes can take business from companies within the industry and thus lower profitability.
An example of a substitute for printed books is Kindle e-books. These products are different where printed books can be physically handled whereas Kindle e-books need to be accessed using an electronic device, such as a Kindle e-reader or on a Kindle mobile app. Although these products are not solely similar products marketed differently like Pepsi and Coca-Cola sodas, they still serve the same purpose, being reading content. Kindle e-books are a threat to printed books since they are substantially priced lower than printed books as they require no raw material to produce.
Degree of Rivalry
The force of degree of rivalry assesses how intense competition is in the marketplace. Industries where rivalry is intense can often have lower profitability. Whether rivalry will have a large impact on profitability depends on whether there is growth within the industry, product differentiation, switching costs of buyers, concentration/balance of competitors, and if economies of scale exist. Degree of rivalry among competitors is determined by the number of existing competitors and what each competitor’s capabilities are and to what extent.
Rivalry will be more intense when low barriers to entry and high scope for profits leads to a crowding effect. High competitiveness within an industry where the number of competitors continuously increases with few competitors existing involves perpetual sensitive responsiveness to changing consumer trends; High pricing pressures in in these types of industries.
Threat of New Entrants
The force of threat of new entrants examines the barriers to entry of an industry, whether they are higher or lower. The higher the barriers are, the less threat there is to existing entrants; if barriers to entry are lower, it will be easier for new competitors to enter the market, threatening the business of existing competitors.
New entrants into an industry can also have an impact on industry profitability. If there are low barriers to entry, new companies can easily emerge and take away market share from existing companies. The threat of new entrants is therefore dependent on economies of scale, product differentiation, brand Images, switching costs, access to distribution, and government policy. The clothing and apparel manufacturing industry is an example of an industry with low barriers to entry as there are low regulatory barriers, low initial capital requirement and a low level of technical know how and research required.
The five forces analysis illustrates a general overview of the industry. Depending on whether the forces generate headwinds or tailwinds, the industry can be more attractive or less. When the forces allow companies to create a wider economic moat, they increase industry profitability and attractiveness. Consequently, such an analysis during commercial due diligence is a strong focus during a strategic merger or acquisition.