Value investors use fundamental analysis to determine if a stock is a good deal. They examine the share price in conjunction with company earnings, the upward or downward trend of revenue and net income, debt level, cash flow and other such financial health metrics. When a stock is priced low but the company has sound fundamentals, investors consider this a value buy. Perhaps the most skilled investor of all time, Warren Buffett, used value investing to amass his substantial wealth.
Thorough fundamental analysts evaluate more than the company itself. They look at the entire industry and identify external factors that affect the company. Even the most fundamentally sound companies face constant external threats; how they respond to them plays a big role in their continued success. The Porter's Five Forces model considers five common external forces and provides a framework through which investors can determine which of these forces poses the biggest threat to a company. Let us take a look at video game producer Electronic Arts through the prism of Porter's Five Forces.
The Five Forces Model
Michael E. Porter, a Harvard Business School professor, developed the Five Forces model in 1979. He understood the value of analyzing external forces but felt the models available at the time, such as the strengths, weaknesses, opportunities and threats (SWOT) analysis, were insufficient and lacking in scope. He approached his model with the idea that it would probe specific external threats more deeply.
The Five Forces model considers external forces from both horizontal and vertical competition. Horizontal competition comes from rivals in the industry and substitute products from other industries. Vertical competition is found up and down the supply chain; it manifests in the bargaining power of suppliers and buyers.
The model examines horizontal competition from industry competition, the threat of new entrants and the threat of substitute products, and vertical competition from suppliers and buyers.
Electronic Arts: An Overview
Electronic Arts, Inc. (NASDAQ: EA) develops, markets and distributes video games. The company was founded in 1982 and has its headquarters in Redwood City, Calif. Its most popular titles include "Madden NFL," "NCAA Football," "NBA Live" and "FIFA," all of which are published under the company's EA Sports label. Additionally, EA offers adventure games, such as "Mass Effect," "Dead Space" and "Army of Two."
The company is a dominant player in the video game industry and has huge brand name recognition among gamers. Its 2016 market capitalization stands at $20.5 billion. EA is fundamentally sound, with return on equity (ROE) above 28%, operating margin above 22%, low debt and good cash flow. Its main competitors include Activision Blizzard, Ubisoft Entertainment and Nintendo.
Of Porter's five forces, industry competition represents the biggest threat to EA. Video game players do not tend to have high brand loyalty toward particular game manufacturers. Unlike car buyers, many of whom are exclusively Chevy people or Ford people, gamers simply want the best games and are not typically concerned with who makes them. A gamer who, for example, is all in on EA but shuns Activision is rare.
Unlike Coke or Nike, EA cannot rely on its brand name to give it an edge over competitors. The company must continue to develop the most cutting-edge video games and effectively market them to the gaming public. Its Madden franchise, for instance, has been the gold standard for football games for two decades. Players choose the game because it is the most advanced football video game on the market, not because it is made by EA.
EA must continue to dominate the sports market while ramping up its adventure games, a market that Activision Blizzard currently dominates with offerings such as "Call of Duty" and "World of Warcraft."
Threat of New Entrants
The threat of new entrants is high in the multimedia and graphics software industry, and particularly in the video game production segment. The segment's barriers to entry are low, with minimal government regulation and manageable costs. Programming video games does not require expensive or hard-to-find materials; more critical is the intellectual capacity to develop a new or innovative concept and bring it to life through effective programming and coding. One brilliant idea that leads to a blockbuster game is all it takes for a new company to catapult itself into the top echelon of video game producers.
Bargaining Power of Buyers
Buyers' bargaining power rounds out the external forces that pose the most serious threats to EA. Video games are highly discretionary purchases. Consumers can be selective about where they spend their money. Moreover, gamers tend to espouse a pack mentality when it comes to the games they purchase and play. Buyers hold a lot of sway over the industry, and one bad or disappointing offering that causes a revolt from the gaming community can devastate a company. The video game console manufacturer Sega learned this the hard way when its Dreamcast console was widely panned, leading to gamers taking their dollars elsewhere and ultimately decimating the brand.
Threat of Substitutes
A substitute is not a similar product from a competitor, such as a football video game made to compete with "Madden," but a product in a different niche that a consumer might choose in place of a company's offering. App-based games, which users can play on smartphones or tablets, represent the best example of a substitute for EA's products. The advantage of app-based games is that they are usually free or very inexpensive. They almost always cost under $5, whereas a new EA game can cost $50 or more. However, smartphone and tablet games have not approached the point where the gaming experience is anywhere near an EA game. As of 2016, substitutes do not represent a strong threat for EA.
Bargaining Power of Suppliers
EA's suppliers provide physical products and materials, such as computer hardware and software, graphics cards, and network infrastructure, and intellectual property, such as video game content and software code. Because a wide array of ingredients make up an EA game, the company uses a wide array of suppliers. Suppliers in unique niches, or who possess a needed supply that is hard to find elsewhere, may possess a degree of bargaining power. However, the company's diversification among suppliers means that one or two suppliers raising prices represents only a small increase in the company's total cost of doing business.