Porter Analysis
A framework for evaluating the interaction of financial
decisions and non-financial decisions in terms of their impact
on firm value
P.V. Viswanath
Financial Theory
and
Strategic Decision-Making
Before Valuation
A key part of Valuation is forecasting
the future cashflows of the firm.
For that, it’s important to have a good
understanding of what the firm is, its
strengths, where it is, who its
competitors and their strengths.
A firm does not operate in a vacuum.
Forecasting cashflows is impossible
without knowing the environment.
Porter Analysis
Porter’s Five Forces model Analysis is a
systematic way of analyzing the
industry environment in which the firm
finds itself.
Following this, it is necessary to do a
SWOT-type analysis to evaluate the
firm within this environment.
Using Porter Analysis
Porter Analysis is usually used for
strategic purposes, such as in selecting
firms for acquisitions.
We will look at it in terms of where and
how financial decisions and financial
variables matter.
The following slides will not explicitly
discuss financial variables, but the point
is to keep them in mind in our
discussion of strategic decision-making.
Financial Decisions
What are the corporate decisions that
you think of as financial?
Financial Decisions
Broadly speaking, we can divide corporate
decisions into those that affect the composition
of the left-hand side of the balance sheet (i.e.
the assets side) and those that affect the
composition right hand side of the balance
sheet (i.e. the liabilities side).
The first category of decisions are operating
decision.
Financial decisions are those that affect the
composition of the liabilities of the firm, i.e the
second kind.
Financial Decisions
Here is a partial list of financial decisions:
Short term financing
Long-term financing or the capital structure
decision
Decisions regarding the maturity of debt
Decisions regarding currency in which to
borrow
Decisions regarding borrowing at fixed rates
or floating rates
Decisions to hedge interest rates or not
Financial Decisions
Decision to list on an exchange
Decision to pay dividends
Credit terms, such as number of days
credit allowed, cash discounts, etc.
Hedging
Determining cost of capital and cost of
capital are processes that have to do with
financial decisions, but are not themselves
financial decisions.
Financial Decisions
Many operating decisions will need to
modifications of financial decisions. For
example if the firm decides to sell abroad, it
may then need to hedge its foreign currency
inflows.
Normally operating decisions are primary, they
are taken first, and they impact the financial
decisions. This is not to say that the operating
actions are taken first, just that these decisions
are taken first, e.g. which industry to operate
in, which market to target, where to locate a
plant etc.
Financial Decisions
We are interested, here, in financial decisions that are
going to affect or limit or enhance the operating decisions
of the firm and the cashflows generated by the operating
decisions.
This means that there will have to be some sort of higherlevel coordination between the financial decision-makers
and the operating decision-makers.
For example, a decision on credit policy will have to be
coordinated with the decision as to which market segment
to target – certain markets may require more liberal
provision of credit.
Similarly, taking on financial leverage could lead to the
firm being perceived as aggressive and hence impact the
extent of competition for the firm.
Five Forces model of Porter
Ease of entry of competitors
How easy or difficult is it for new entrants to start to compete,
which barriers do exist?
Threat of substitutes
How easily can the product or service be substituted, especially
cheaper?
Bargaining power of buyers
How strong is the position of buyers, can they work together to
order large volumes?
Bargaining power of suppliers
How strong is the position of sellers, are there many or only few
potential suppliers, is there a monopoly?
Rivalry among the existing players
Is there a strong competition between the existing players, is one
player very dominant or all all equal in strength/size?
Government Intervention
Can government policies be used to the advantage of the firm?
From http://www.valuebasedmanagement.net/methods_porter_five_forces.html
Porter: Five Strategic Forces
www-mime.eng.utoledo.edu/people/faculty/rbennett/engineering_management/Powerpoint%20Slides/ch09.ppt
New Entrants: Barriers to Entry
Economies of Scale
To the extent that there are economies of scale, it will be
difficult for a new firm to come in and compete with
established firms.
Product Differentiation
To the extent that the firm’s products are distinct and noncopiable, new firms won’t be able to come in and take away
customers.
Brand Identification
To the extent that there is brand identification, customers
will remember the firm’s product and will resist switching.
Switching Cost
If it is costly for the customer to switch, new entrants won’t
be able to convince them to do so.
New Entrants: Barriers to Entry
Access to Distribution Channels
If the firm has preferential or monopolistic access to
distribution channels, it is more resistant to competition.
Capital Requirements
If capital requirements are high, new under-capitalized firms
won’t be able to enter the industry.
Access to Latest Technology
If technology is important in the industry, new firms are less
likely to have access to them, which is good for established
firms.
Experience and Learning Effects
If experience is necessary for a firm to figure out how to
operate efficiently, established firms have a distinct
advantage.
Barriers to Entry: Examples
Regulatory restrictions (e.g. banking license)
brand names (e.g. Xerox, McDonalds – can
develop customer loyalty; hard to develop
and/or imitate)
patents (illegal to exploit without ownership;
e.g. new drugs – cf. also RIM)
A small co., NTP, had a patent on crucial
technology that RIM used for its Blackberry
unique know-how (e.g. WalMart’s “hot
docking” technique of logistics management)
Accumulated experience (cf. learning curve)
New Entrants/ Industry Competition:
Government Action
Industry Protection
Industry Regulation
Consistency of Policies
Capital Movement Amongst Countries
Custom Duties
Foreign Exchange
Foreign Ownership
Assistance Provided to Competitors
Finance and Industry Entry
How can financial strategies make it
more difficult for new firms to enter the
industry and compete with your firm?
Porter: Five Strategic Forces
www-mime.eng.utoledo.edu/people/faculty/rbennett/engineering_management/Powerpoint%20Slides/ch09.ppt
Industry Competition:
Rivalry Among Competitors
Concentration and Balance among Competitors
To the extent that there is no single large competitor, the
firm is better off
Industry Growth
If the industry is growing, there’s more room for everybody;
less pressure on the firm
Fixed Cost
The higher the operating leverage, the more competitors are
going to be hungry for revenue – downside risks are greater
Product Differentiation
If products are differentiated, markets are in a sense,
segmented, and there are no competitors
Industry Competition:
Rivalry Among Competitors
Intermittent Overcapacity
The extent to which firms have overcapacity from time to
time, leading them to find additional sources of orders to
keep resources fully employed.
Switching Costs
The extent to which it’s easy for customers to switch from
this firm to other firms’ products will also determine how
much other firms will exert themselves to get them to switch
Corporate Strategic Stakes
If the strategic stakes are high – for example, if there is only
room for a few players, then firms will fight harder
Industry Competition:
Barriers to Exit
Asset Specialization
If assets are specialized, firms will not want to exit
– quitting the industry can be costly in terms of
lower prices for assets no longer in use.
One-time Cost of Exit
For example, if businesses are required to pay for
any environmental costs before they exit or if they
have to set aside funds to pay for potential future
lawsuits, they are less likely to exit a business
Strategic Interrelationships with Other
Businesses
Emotional Barriers
Government and Social Restrictions
Finance and Fighting Competitors
How can the right financial decision
help overwhelm or outgun existing
competitors?
Porter: Five Strategic Forces
www-mime.eng.utoledo.edu/people/faculty/rbennett/engineering_management/Powerpoint%20Slides/ch09.ppt
Bargaining Power of Suppliers
Number of Important Suppliers
The fewer the number of important suppliers, the
more power they have over the firm, and the greater
their ability to extract producer surplus.
Availability of Substitutes for the Suppliers’
Products
This would reduce supplier power.
Differentiation or Switching Costs of Suppliers’
Products
If it’s difficult for the firm to switch to other suppliers,
the current suppliers can charge more.
Suppliers’ Threat of Forward Integration
To the extent that suppliers might potentially
themselves become competitors, they are less
reliable and need to be looked at strategically
Bargaining Power of Suppliers
Industry Threat of Forward Integration
To what extent is it possible that the entire supplier
industry might integrate forward?
Suppliers’ Contribution to Quality or Service of
the Industry Products
How crucial are suppliers in the maintenance of the
quality of industry products? Clearly, this will
determine supplier power. Also, if this is an
important factor, then the supplier industry might be
more important, and might integrate forward.
Total Industry Cost Contributed by Suppliers
This goes to the same issue as above, but from a
more quantitative perspective.
Importance of the Industry to Suppliers’ Profits
Finance and Suppliers
How can financial decisions help redress
the balance of power between the firm
and its suppliers?
Bargaining Power of Customers
Number of Important Buyers
The greater the number of important buyers, the less power
does the firm have to manipulate prices
Availability of Substitutes for the Industry Products
The impact of this on price elasticity of demand for the
industry’s products is obvious.
Buyer’s Switching Costs
This is relevant both in terms of switching to competitors’
products and switching to products manufactured by other
industries.
Buyer’s Threat of Backward Integration
The buyer might choose to integrate backward and
manufacture his input goods, himself. This means that
buyers have to be looked at strategically; they also have
more power over the prices they are charged.
Bargaining Power of Customers
Industry Threat of Backward Integration
The entire buyer industry might integrate backward.
Contribution to Quality or Service of Buyer’s Products
The greater the contribution of the firm’s product to the
quality of the product, the greater the power of the firm.
On the other hand, this might also impel the buyer to
integrate backward.
Total Buyer’s Cost Contributed by the Industry
This is similar to the previous point, but in a more
quantitative fashion.
Buyer’s Profitability
The more profitable buyers are, the more amenable they are
to paying more for their input products.
Finance and Customers
How can financial decisions help
increase the firm’s economic power visà-vis its customers?
Porter: Five Strategic Forces
www-mime.eng.utoledo.edu/people/faculty/rbennett/engineering_management/Powerpoint%20Slides/ch09.ppt
Substitutes
Some of these points have already been
addressed in looking at buyers/suppliers.
However, it’s useful to consider it again from
the product perspective, rather than from the
perspective of other economic actors.
Availability of Close Substitutes
User’s Switching Costs
Substitute Producer’s Profitability and
Aggressiveness
Where is the substitute product located on the
Price/Value dimensions?
Finance and Competition from
Substitutes
Can financial decisions help the firm
ward off substitutes competing against
its products?
Porter Model Applied:
Pharmaceutical Industry 1990s
Barriers to Entry – Very Attractive
Steep R&D experience curve effects
Large economies-of-scale barriers in R&D
Critical Mass in R&D and marketing
required global scale
Significant R&D and marketing costs
High Risk inherent in the drug
development process
Increasing threat of new entries from
biotechnology companies
Porter Model Applied:
Pharmaceutical Industry 1990s
Bargaining Power of Suppliers
Mostly Commodities
Individual Scientists may have some
personal leverage
Porter Model Applied:
Pharmaceutical Industry 1990s
Bargaining Power of Buyers: Mildly
Unattractive
Buying Process is price sensitive – the
consumer did not pay and the buyer did not
pay
Large power of buyers – plan sponsors with
an incentive to contain costs
Mail-order pharmacies obtain large discounts
on volume drugs
Large aggregated buyers – hospital suppliers,
large distributors, government institutions
Porter Model Applied:
Pharmaceutical Industry 1990s
Threat of Substitutes: Mildly Unattractive
Generic drugs weakening branded drugs
More than half the patent life spent on
product development and approval process
Technological development is making
imitation easier – reverse engineering
Consumer aversion to chemical substances
erodes the appeal for pharmaceutical drugs
Porter Model Applied:
Pharmaceutical Industry 1990s
Intensity of Rivalry: Attractive
Global Competition Concentrated Amongst fifteen
large companies
Most companies focus on certain types of disease
therapy
Competition amongst incumbents limited by patent
protection
Competition based on price and product
differentiation
Government intervention increases rivalry
Strategic alliances establish collaborative agreements
among industry players
Very profitable industry, but declining margins
Resource-based Views of the
Firm: Tangible Assets
Tangible assets are the easiest to value, and
often are the only resources that appear on a
firm’s balance sheet.
They include real estate, production facilities,
and raw materials, among others.
Although tangible resources may be essential
to a firm’s strategy, due to their standard
nature, they rarely are a source of
competitive advantage.
Source: David Collis and Cynthia Montgomery
Resource-based Views of the
Firm: Intangible Assets
Intangible assets include such things as
company reputations,
brand names,
cultures,
technological knowledge,
patents and trademarks, and
accumulated learning and experience.
Firm Resources:
Organizational Capabilities
Organizational capabilities are not factor
inputs like tangible and intangible assets
They are complex combinations of assets,
people, and processes that organizations use
to transform inputs into outputs.
Includes a set of abilities describing efficiency
and effectiveness: low cost structure, “lean”
manufacturing, high quality production, fast
product development.
Putting things together
Now that we have looked at the firm’s
environment and its assets, we need to look
at the firm’s strategy within this environment
and how this relates to the other parties
identified in the “five forces model.”
We must keep in mind, however, that our
objective is not to craft new strategy for the
firm, but rather to appreciate its current and
potential strategy in
forecasting future cashflows
Evaluating investment risks
A useful place to find relevant information is
the firm’s 10-K filing, particularly the “Risk
Factors section.”
The impact of finance
Think again about capital structure,
about financial risk management, about
dividend policy and how they might
affect all the issues relating to value
creation in a firm.