Level 1 CFA® Exam:
Porter's Five Forces
As part of their work, analysts and portfolio managers study the relations between the economic situation and its influence on particular industries. Using various approaches, they try to develop forecasts regarding the future economic results of different industries. They also compare the results of their projections with those of other analysts. If there are differences between their forecasts and consensus forecasts (that is the average of all market forecasts), it means that there is an investment opportunity to be used.
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Industry Life-Cycle Stages
We can classify industries according to industry life-cycle stages.
An industry may be in:
- the embryonic stage,
- the growth stage,
- the shakeout stage,
- the mature stage,
- the declining stage.
While analyzing industries that are in different life-cycle stages, we should remember that each life-cycle stage has its own characteristics. We describe industry life-cycle stages in the next lesson. Here we only talk about the relationship between the industry life-cycle stages and the so-called experience curve.
When an industry life-cycle stage changes, so does the experience curve. The experience curve is a curve representing direct total cost per unit of good as a function of cumulative output. This curve slopes down because as the production increases, fixed costs are spread over a larger number of units produced. The reason for this decline is also an increase in labor efficiency, as well as advances in production methods and product design.
When analyzing an industry, keep in mind that individual industries have different characteristics. They differ in the level of competition, barriers to entry, types of customers, and so on. Also, required rates of return on capital differ for different industries.
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An important element of strategic analysis is Michael Porter's five forces framework which includes 5 determinants of the intensity of competition in the industry. These determinants are:
- the threat of substitute products, which has a negative influence on demand for a given product,
- the bargaining power of customers, which intensifies competition and exerts price pressure on suppliers,
- the bargaining power of suppliers, which increases prices of raw materials used by companies in production,
- the threat of new entrants to the industry, whose intensity is influenced by barriers to entry. The lower the barriers, the stronger the competition in the industry.
- the rivalry among existing competitors in the industry, which depends on the level and structure of competition in the industry. In industries that for example are heavily fragmented or are characterized by high fixed costs or provide homogenous products, the competition is usually very strong.
All of these determinants of the intensity of competition require attention, but it is believed that special attention should be paid to the threat of new entrants to the industry and the intensity of rivalry in it. This is so because a considerable threat to a company's performance is caused by existing and future competition.
- A strategy group is a group of companies usually from the same industry that similarly run their businesses and use similar business models.
- We can classify industries according to industry life-cycle stages. An industry may be in the embryonic stage, the growth stage, the shakeout stage, the mature stage, or the declining stage.
- The experience curve is a curve representing direct total cost per unit of good as a function of cumulative output.
- The analysis of (1) the environment in which companies operate and (2) how this environment affects their business strategy is called STRATEGIC ANALYSIS.
- Porter's five forces framework includes 5 determinants of the intensity of competition in the industry: the threat of substitute products, the bargaining power of customers, the bargaining power of suppliers, the threat of new entrants to the industry, and the rivalry among existing competitors in the industry.