Using Porter’s Five Forces to Determine a Company’s Moat

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”

Investing in companies whose competitive landscape we don’t understand offers some challenges; we need to understand the company and industry to become good investigators. Enter Porter’s Five Forces, which provide keys to understanding a company and its competitive advantages or lack of them.

Using Porter’s Five Forces, we can examine many companies to determine their competitive advantage or “moat”. Porter provides us with five different topics, giving us a wide scope to analyze a company.

Using these forces, we can analyze different companies with those templates as examples to study, especially when we begin to study a new company or industry. As we will learn, the rivalry doesn’t only come from competitors but other forces as well.

In today’s post, we will learn:

Okay, let’s dive in and learn more about Porter’s Five Forces examples.

The Importance of Porter’s Five Forces

One of the best ways to analyze competition among companies remains using Porter’s Five Forces model.

Harvard Business School’s Michael Porter created the model in 1979. Porter named the model “Five Forces”, which looks at five specific factors to determine whether a company can remain profitable relative to others in the industry.

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The collective power of the Five Forces determines the profitability of a sector and the attractiveness of the sector to potential entrants.

For example, if the forces offer fierce competition (i.e. airlines), almost no one will earn attractive returns. But if the competition remains milder, then the possibility of better returns exists (i.e. soft drinks).

Understanding the competitive forces, and their underlying causes, reveals the roots of an industry’s current profitability while providing a framework for anticipating and influencing competition (and profitability). A healthy industry structure should be as much a competitive concern to strategists as their company’s own position.” 

Breaking Down Porter’s Five Forces – A Quick Guide

Porter envisioned understanding the competitive forces in play and the overall industry structure as crucial to effective decision-making, along with developing strong competitive strategies for the future of any company.

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Graph courtesy of Business-to-you.com

Understanding these forces gives us a better overall understanding of the company and the industry it operates in.

One of Buffett’s superpowers, among the many, remains his ability to size up the competitive landscape and pick the “winners” for a particular industry.

We need to look no further than his portfolio, which contains many “moat” type companies:

  • Apple
  • American Express
  • Moody’s
  • Coca-Cola

Let’s explore Porter’s Five Forces to determine what forces shape industry competition.

  1. Threat of new entrants
  2. Threat of substitutes
  3. Bargaining power of customers
  4. Bargaining power of suppliers
  5. Competitive rivalry

Breaking down Porter’s Five Forces gives us:

Threat of New Entrants

The above factor determines how easily a competitor can enter the market. As more companies enter a market, existing companies face the pressure of losing customers or potential profits.

The threat to entrants remains high if companies can enter a market easily, barriers remain low because costs remain low, or the technology is unprotected or not patented.

For example, the payment space exploded recently because of the ease of creating an app allowing different payment abilities such as trading stocks, transferring money, or buying products. The ease of use led to many competitors joining the space quickly because of the low cost and ease of creating code to solve a problem.

Some common barriers to entry to consider:

  • High costs of entry
  • Customer loyalty to existing brands
  • Complex technology
  • Government regulations
  • Economies of scale
  • Large capital requirements

Threat of Substitutes

This factor determines how easily customers can switch between competing products or services. If any products or services can fill a customer’s needs, those products become interchangeable.

Companies can lose market share when products or services become interchangeable. It can worsen profits as companies begin to compete on price as everyone starts the race to the bottom.

Another risk is if the product or service becomes so easily replicable, they risk the customer doing it themselves.

Switching costs are related to this force; for example, if a customer has no friction from changing between each service, such as Netflix or Hulu, nothing prevents them from switching as they need.

Some potential threats to a company include:

  • The number of substitute products or services
  • The quality of substitute products or services
  • The price of substitutes
  • Competitions profits
  • The competitor’s aggressiveness
  • Likelihood of switching products and services

Bargaining Power of Customers

This force determines how price changes affect customers’ buying decisions and their ability to lower prices. For example, when fewer customers are in play, buyers have greater power, but the amount of substitute products remains high.

All of this could cause prices to fall and profits to shrink.

Buyers have less power overall when they buy in smaller amounts and have fewer substitute choices.

Conditions affecting this force include:

  • Number of customers
  • Quantity of purchases
  • Substitutes available
  • Buyers price sensitivity

Bargaining Power of Suppliers

This factor considers how many suppliers a company has access to, plus how easily suppliers can increase prices or reduce product quality.

The larger pool of suppliers a company has to choose from, the easier to switch to lower-cost suppliers or find higher-quality products. If a company has fewer suppliers, they face the potential of higher prices or lower-quality products because of the supplier’s power position.

Items to consider that can affect a supplier’s power over a company:

  • Number of suppliers
  • Supplier size
  • Company’s ability to find alternatives
  • The uniqueness of the supplier’s product
  • Switching costs between suppliers

Competitive Rivalry

The competitive rivalry force examines how fierce the industry competition is. The force also compares the quality of the products and services of the competition.

Competition can remain high when an industry has many similar size companies and similar power. For example, the auto industry has many companies of similar size, including Ford, Honda, GM, and Tesla.

In this scenario, switching costs for customers remain low, which leads to aggressive advertising and marketing campaigns and lowering of prices to attract customers. All of these strategies can lead to lower profits long-term.

Some items that could affect competitive rivalry include:

  • Customer loyalty to brands
  • Number of competitors
  • Industry growth
  • Differences in products

For the next section, we will use the above framework to work through pizza company Domino’s to give us an example of how this analysis could work.

Porter’s Five Forces Example: Domino’s Pizza

Domino’s Pizza ($DPZ) is a leading international fast-food chain with an established, strong position in the global fast-food industry with a market presence in over 85 countries.

Domino’s currently carries a market price of $385, with a market cap of $13.8 billion. Last fiscal year ending January 2022, the company did $4.33 billion in sales, an increase of 5.8% from the previous year.

The company holds the number two spot relative to other pizza operators, Yum Brands (Pizza Hut) at $34.2 billion and Papa Johns at $3.1 billion.

Let’s examine the Five Forces for Domino’s Pizza.

dominos pizza

Threat of New Entrants:

The threat of new entrants reflects how new market players might disrupt existing market operators. If the fast-food industry continues to see profits and barriers to entry remain low, those factors will attract more businesses leading to higher threats of new entrants.

Below are a few factors helping Domino’s reduce the threat of new entrants.

  • Entry into the fast-food sector requires substantial capital resources for investment. Competitors can mitigate some force by offering product differentiation or creating a unique experience.
  • Domino’s Pizza will face lower threats if there remains an existing regulatory framework that imposes strict, time-consuming regulations on new market entrants, discouraging many from entering the market.
  • The threat will remain low if brand loyalty remains high and the psychological switching cost for customers remains high. If Domino’s continues to excel at customer service and grow brand loyalty, it reduces the threat.
  • If entrants face struggles establishing distribution channels, which remains one of Domino’s super powers, Domino’s will see lower threats. Domino’s does a superb job of creating long-term contracts with distributors widening access to different markets.

The Threat of Substitute Products

The pizza industry’s wide array of substitute products makes the competitive climate a challenge for Domino’s and other pizza players. The high substitute threat illustrates how customers can use alternative products to feed their fast food needs and pizza substitutes.

Some threats Domino’s faces:

  • Cheaper products
  • Switching costs
  • Quality increases or decreases

Here are some ways Domino’s can combat these threats:

  • Domino’s can combat the threat of quality substitutes by focusing marketing and advertising on their excellent ingredients compared to competitors. By emphasizing the better ingredients, they illustrate the supremacy of its products.
  • Domino’s can provide evidence of a better customer experience by utilizing mobile apps to make the ordering and paying process simpler. They can also offer different combination meals to heighten their buck’s sense of greater bang.
  • Domino’s can increase brand loyalty by offering different incentives to become members of a loyalty program and special deals. They can also encourage local stores to embrace regular guests by acknowledging them and offering them special deals.

Bargaining Power of Buyers

Bargaining power illustrates the pressure customers exert on a business to gain high-quality products and excellent customer service for affordable prices.

This force impacts Domino’s directly by lowering profits and creating higher industry competition. Domino’s has better growth outlooks and higher profit margins when the force is lower.

Domino’s can fight this power by diversifying their customer base and growing the same base. They can achieve these goals by introducing new products, targeting new market areas, and adopting strategies around product diversification.

For example, marketing and advertising offer helpful strategies to promote the new products.

Building loyalty via a better customer experience using technologies such as better mobile apps, driverless delivery, and a better online experience will reduce the customer buying power.

If Domino’s adopts these strategies, it can strengthen its position in the fast-food market.

Bargaining Power of Suppliers

The bargaining power of suppliers for Domino’s exists in their ability to limit product supply, reduce quality, or increase prices. When suppliers have a strong footing, it impacts Domino’s profits while increasing its competition, thus impacting Domino’s growth prospects.

Domino’s can offset some of the power of suppliers by:

  • Building an efficient distribution chain with multiple options of suppliers.
  • Experimenting with substituting different materials so that if the price of one product rises, they can pivot to another material.
  • Developing dedicated suppliers whose company’s livelihood depends on Domino’s. A lesson Domino’s could learn from Costco, Walmart, and Nike is the growth of third-party suppliers whose business survival depends on each respective company. By creating third-party suppliers, Walmart, for example, reduced supplier bargaining power.

Rivalry Among Existing Companies

The fast-food and pizza industry contains many strong players with local and international connections. Many competitors in both industries can negatively affect Domino’s market share. For example, Pizza Hut remains a top competitor for Domino’s. Another top competitor, Papa Johns, has grown in scope and size, putting pressure on Domino’s to improve its delivery and execution.

Domino’s can continue to compete by:

  • Strengthening the differentiation between it and competitors by focusing on the needs and expectations of customers. It can increase differentiation by using its technological advantages and customer loyalty programs.
  • Increasing switching costs by further embracing loyalty programs.
  • Spending additional money on R&D to identify new customer segments to continue growth.
  • Partnering with competitors, which can be mutually beneficial in some cases.

Examples of Porter’s Five Questions to Ask

Below is a framework of questions you can ask when analyzing a company using Porter’s Five Forces framework. These questions remain a starting point to help get you started.

Threat of new entrants

  • How easily can new entrants gain access to the sector?
  • How capital intensive is the industry?
  • How quickly can competitors enter the fray and compete?

Threat of substitutes

  • How often do customers switch products or services?
  • What kinds of switching costs exist?
  • What technological disruptions exist?

Bargaining power of buyers

  • How many buyers does the company have?
  • How big are the orders?
  • What kind of switching costs exist?
  • Do the buyers dictate terms to the company?

Bargaining power of suppliers

  • How many potential suppliers does the company have?
  • How many suppliers do they use for their key products or services?
  • How unique of a product or service do they offer?
  • What kind of switching costs exist?

Competitive Rivalry

  • How many competitors does the company have?
  • Who are they? Have they established brands?
  • How does the quality of the products and services compare to the company you analyze?

The above questions give you a great starting point to the Domino’s example we worked through.

Investor Takeaway

By analyzing Domino’s Pizza using Porter’s Five Forces model, we can see a complete picture of the company, industry, and what drives profitability.

Using these exercises gives us a good sense of how a company operates, what kinds of risks exist, and how the company navigates its industry or sector.

By walking through different companies using Porter’s Five Forces examples, we can better understand both companies and the sectors they operate within. Part of the knowledge we gain can help us make better investment decisions and avoid potential value traps.

Part of the challenge to investing remains understanding business models and how they make money. And like investing, knowledge compounds.

And with that, we will wrap up our discussion regarding Porter’s Five Forces examples.

Thank you for reading today’s post, and I hope you find something of value. If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave

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