What Are Porter's Five Forces?

The Porters Five Forces model shows investors which market forces pose the biggest threat to a company. The model examines external forces from both a horizontal and vertical competition perspective. Value investors use fundamental analysis, including Porters Five Forces, to determine if a stock has potential as an investment. Fundamental analyses 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 financial health metrics.

Key Takeaways:

  • The Porters Five Forces model shows investors which external forces pose the biggest threat to a company.
  • The model was developed in 1979 by Michael E. Porter, a Harvard Business School professor.
  • The five forces model considers external forces from both a horizontal and vertical competition perspective.
  • In the case of the video game producer Electronic Arts, industry competition is the biggest threat.

Understanding Porter's Five Forces

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, and how they respond to them plays a significant 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 the forces pose the biggest threat to a company.

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. Still, he felt the models available at the time, such as the strengths, weaknesses, opportunities and threats (SWOT) analysis, were insufficient and lacking in scope. He developed the model with the idea that it would probe specific external threats more deeply.

The five forces model considers external forces from both a horizontal and vertical competition perspective. Horizontal competition comes from rivals in the industry and substitute products from other industries. Vertical competition comes from the supply chain, and is manifested in the bargaining power of suppliers and buyers.

The model examines horizontal competition from the perspectives of industry competition, the threat of new entrants, the threat of substitute products, and vertical competition from suppliers and buyers.

We examine the video game producer Electronic Arts through the prism of Porter's Five Forces.

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 market capitalization in June 2020 stood at $37.7 billion. EA is fundamentally sound, with return on equity (ROE) at 21%, operating margin of 26%, low debt, and good cash flow. Its main competitors include Activision Blizzard, Ubisoft Entertainment, and Nintendo.

Industry Competition

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. EA's 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 have 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 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 close to that of an EA game.

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. Intellectual property includes 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 of unique materials 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.