Lesson 1 of 8
Five forces as a checklist
Porter's frame asks five questions about an industry's structure. Scoring it out of five turns a diagnostic into a verdict and loses everything useful in it.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The five forces are threat of new entrants, rivalry among existing firms, bargaining power of suppliers, bargaining power of buyers, and threat of substitutes.
- Porter's own recommended use is to understand the underpinnings of competition and the root causes of profitability, not to declare an industry attractive or unattractive.
- Mauboussin, Callahan and Majd argue that entry and rivalry deserve deeper treatment than the other three, which is a useful correction to giving all five equal weight.
The five forces frame is the most widely used and most widely misused tool in this subject. Misused, it produces a score. Used properly, it produces five questions whose answers are facts about an industry.
Five questions, and what an answer to each looks like
| Force | The question | Evidence that answers it |
|---|---|---|
| Threat of new entrants | What would it cost, and take, to build this from nothing | Capital intensity, licence requirements, the record of actual entries |
| Rivalry among existing firms | How do competitors compete: on price, or on something else | Price trends, capacity additions, industry margin dispersion |
| Bargaining power of suppliers | Can an input provider raise its price and keep the business | Supplier concentration, input substitutability, contract terms |
| Bargaining power of buyers | Can a customer force a lower price | Customer concentration disclosures, contract length, switching cost |
| Threat of substitutes | What else does the same job for the customer | Adjacent technologies, price of the substitute, its trend |
What the frame is for
Porter's recommendation, as Mauboussin, Callahan and Majd set it out, is to use industry analysis to understand the underpinnings of competition and the root causes of profitability. He argues that the collective strength of the five forces determines an industry's potential for value creation.
But the industry does not seal the fate of its members. An individual company can earn better than the industry average by defending against the forces and shaping them to its advantage, which is why the frame is a starting point for firm-level work rather than a substitute for it.
Why scoring it destroys it
Rate each force out of five, add them up, and you have replaced five facts with one number that contains none of them. The number cannot be checked, cannot be updated when one force changes, and cannot be argued with except as a whole.
Worse, the arithmetic implies the forces are comparable in weight, and they are not. Mauboussin and colleagues make that point directly: the threat of entry and rivalry warrant deeper consideration than the other three. A scoring system that treats supplier power as equal to entry threat has encoded an assumption nobody chose.
What to write instead
Five sentences, each of which could be wrong. Entry costs about this much and takes about this long, and the last two entrants did this. Competitors compete on this dimension, and here is where the price went. This input has these many credible suppliers. The largest customer is this share of revenue, which the filing discloses. And this is what a customer does instead.
Five falsifiable sentences beat one score, because each of them can be checked next year and found to have changed.
Check yourself
What does Porter recommend the five forces be used for?
- Scoring an industry as attractive or unattractive
- Understanding the underpinnings of competition and the root causes of profitability
- Ranking companies within an industry
Show the answer
Answer: B.
The frame is diagnostic. Mauboussin, Callahan and Majd note that some analysts use it to declare an industry attractive, which is not its recommended use.Which two forces do Mauboussin, Callahan and Majd single out for deeper treatment?
- Supplier power and buyer power
- The threat of entry and rivalry
- Substitutes and supplier power
Show the answer
Answer: B.
They argue those two are important enough to warrant deeper consideration than the other three, against the common practice of weighting all five equally.What is the practical defect of scoring the five forces out of five?
- The scale is too narrow
- It replaces five checkable facts with one number that cannot be updated, argued with in parts, or found wrong
- It requires data most companies do not disclose
Show the answer
Answer: B.
A score also implies the forces carry equal weight, which encodes an assumption nobody made deliberately.Sources
- Mauboussin, Callahan and Majd, Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation, Credit Suisse, 1 November 2016: the five forces framework as they set it out, Porter's recommended use of industry analysis, and their argument that entry and rivalry warrant deeper consideration.
- Porter, Competitive Strategy, 1980, as cited in that paper for the five forces.
What this leaves out
- The five forces are reported here as Mauboussin, Callahan and Majd set them out and cite them. This academy has not read Porter's book directly, so no claim beyond what that paper states is attributed to him.
- The scored and described table uses invented round figures and is labelled illustrative.
- A structural reading of an industry says nothing about any individual company's securities, and nothing here is advice about any of them.