Picking a stock means trying to choose the best out of a group of competitors. Porter's Five Forces Model can help by focusing attention on five direct and pertinent questions about the company's ability to compete within an industry.
Named after the Harvard professor who developed it, the Five Forces model is a qualitative analysis tool designed to help an investor identify and analyze the competitive forces that drive an industry. It can be just as helpful for analyzing the strengths and weaknesses of a single company within an industry.
As an example, consider the Coca-Cola Company (KO) as a potential investment, using the Five Forces model.
1. Who Are its Main Rivals?
When you think of Coca-Cola and its competitors, Pepsi is probably the first name that comes to mind, and rightfully so. The two companies have been in
competition since the late 19th century.
Their marquee products are very similar in ingredients and taste, though many
consumers swear loyalty to one brand or the other. Both issue their product in a dizzying array of flavors and variations.
There is one notable difference. Pepsi owns Doritos, Lay's, Cheetos, Tostitos,
and Fritos, among other food brands. If everybody swore off soft drinks tomorrow, Pepsi could still thrive selling salty snacks.
Coca-Cola, on the other hand, has stuck to beverages. But it owns some beverage brands that might surprise some of their customers, like Minute Maid, Powerade, Gold Peak Tea, Dasani, and Vitaminwater.
Coke is betting that, if people swear off soft drinks, they've still got to drink something. And it's worth noting that their focus is on healthy alternatives.
Coca-Cola also competes directly against the Keurig Green Mountain Group. In addition to those two name brands, the company also owns a surprising range of beverages including Schweppes, RC Cola, Hires Root Beer, and Nehi.
The upshot on the question of its rivals: As consumer tastes and trends shift, Coca-Cola could be left vulnerable, but the brand has a loyal following and the company has hedged its bets by moving with the beverage trends. The risk in this area is moderate.
2. How Likely Is a New Entrant to the Industry?
There are new entrants to the beverage industry all the time, but can they gain a foothold to equal Coke or Pepsi? The two companies between them have locked down licensing deals with every fast-food chain. They've gained significant shelf space in every supermarket and mini-market.
A new name would have to have a very positive and very viral image or spend a fortune to create the type of brand recognition Coca-Cola enjoys.
It seems more likely that either Coke or Pepsi would buy the newcomer and add it to the mix. But anyone investing in Coca-Cola should at least keep an eye on the latest trends in non-alcoholic beverages.
3. What Could Buyers Purchase Instead?
Coca-Cola also has to contend with what buyers could purchase instead of its
If the rise of Starbucks has shown anything, it is that people really do love a cup of coffee in the right environment. Coca-Cola purchased a stake in Green Mountain Coffee Roasters, the maker of Keurig, possibly for this reason.
Buyers can also choose beverages such as freshly made smoothies or fresh-pressed juices instead of Coca-Cola's bottled beverages. As more people become health-conscious, the threat that buyers will substitute a different drink for Coca-Cola looms as a real possibility.
4. What Bargaining Power Do Buyers Have?
When it comes to the bottled beverages market, buyers have a fair amount of
bargaining power, and this affects Coca-Cola's bottom line directly.
Coca-Cola does not sell directly to its end users. It mostly deals with
distribution companies that directly service fast-food chains, vending machine companies, college campuses, and supermarkets.
Demand leads the purchases, but Coca-Cola also has to keep an eye on that
end price. Ultimately, that means it has to sell its products to distribution networks at prices low enough that they can sell to the end-user at a competitive price.
Moreover, Coca-Cola's pricing has to stay somewhat consistent with each outlet. McDonald's does not sell a Coke for 99 cents one day and $1.03 the next. As Coca-Cola's cost of goods sold (COGS) fluctuates due to materials, transportation, or manpower, either the beverage company or its distributors have to absorb the loss.
This is a real risk, but it is one that every other entrant in the beverage mass market would face.
5. What Bargaining Power Do Suppliers Have?
This is the final competitive force to consider: Coca-Cola’s suppliers. As big as the company is, and as many long-term contracts as it must have with suppliers, the cost of its ingredients is not entirely within the company's power.
In particular, sugar is a commodity and its price varies over time. One season's poor harvest could affect sugar prices and increase Coca-Cola's raw materials costs.
Thanks to contracts the company likely has in place, the effect would be minimal unless those poor harvest conditions lasted for several years.
Buy or Not?
No analytic tool can tell you whether to buy a stock or not. But understanding the competitive environment in which the company operates can go a long way towards helping you make the decision.