Michael Porter’s Five forces of the Industry Competition

Michael Porter’s work in Strategy
Profitability(Returns on Invested Capital ROIC) of selected US Industries (1992-2006)

Michael Porter made an attempt to analyze why the industries are varying between minimum of 6% and maximum of 41%. And the outcome of his analysis is the FIVE FORCES ANALYSIS.

Five forces of the Industry Competition

#1 Threat of New Entrants (aka Barriers to Entry)
All the below factors would likely push up the barriers to the entry, we will see one by one

  • High Economies of Scale: MES(Minimum Efficient Scale) is pointed in the below graph. If the industry is characterized by high MES, individual players in that particular industry cannot afford to play at that cost and if they choose somewhere less than the MES point then the cost-per-unit would me more and hence subsequently they would be thrown out of markets.

So whenever economies of scale is high which is followed by high MES, it restricts more number of players entering into the market.

  • High Product Differentiation/ Brand Equity: example Audi brand
  • High Capital Requirements: example Airline industry
  • High Switching Costs: It refers to the willingness of the customers to switch from the existing products to the new entrant products in the market. The more this cost is, the lower customers would be willing to switch.
  • High cost of accessing Distribution Channels: example FMCG dist channels
  • Absolute Advantages: like Experience, Technology, IPR, etc. These are irrespective of the scale of what we are operating on. ?? what is experience curve effect? first movers affect?
  • High Expected Retaliation: If the industry is characterized with the behavior associated to the players fighting whenever they essentially have a threat of a new entrant coming in(sth which is seen in the past), like Airline industry because of low levels of profits
  • High Level of Government Protection

Looking from an incumbents perspective, it is always good to have high barriers to entry.

Higher Barriers to Entry -> High Industry Attractiveness -> Higher Levels of Profitability

This is the only force which we need to keep up in order to have the Industry Attractiveness high. In current markets even this force is going down and business is becoming more and more difficult.

#2 Bargaining Power of Suppliers
Suppliers are likely to be powerful if:

  • Few Firms Dominate Supplier Industry: for example there are only two major suppliers in Airline Industry whereas there are 100s of airlines operating on them.
  • Few substitutes for Supplier Products (SP)
  • Buyer(industry player) not an important customer for supplier
  • Supplier is important from a (price/quality) ratio as far as the buyer is concerned
  • Supplier is Highly Differentiated
  • Supplier is able to induce high Switching Costs: The costs the market player in the industry has to bear in switching between the suppliers.
  • High Threat of Forward Integration by Supplier: Boeing(a manufacturing company) starting an airlines
  • Low Threat of Backward Integration by Buyer: Indigo(airline players) starting to manufacture airplanes
  • Rivalry among Competing Firms

Lower the suppliers are fragmented, the higher power they exhibit, so make sure the suppliers are fragmented.

Higher Bargaining Power of Suppliers -> Lower Industry Attractiveness -> Lower Levels of Profitability

#3 Bargaining Power of Buyers
Buyer groups are likely to be powerful if:

  • Buyer concentration is high (buyers of the industry product)
  • Buyer purchase accounts for a significant fraction of supplier’s sales
  • Products are undifferentiated
  • Buyers face few switching costs: between two products in the same industry
  • Buyer’s industry earns low profits? like walmart
  • Buyer presents a credible threat of backward integration

Higher Bargaining Power of Buyers -> Low Industry Attractiveness -> Lower Levels of Profitability

#4 Threat of Substitute Products
Threat of Substitute Products is high when

  • Close substitutes available
  • Low Switching Cost: between the substitutes (which may not be in the same industry)
  • High Price Value Performance of Substitutes
  • High Profitability of Producers of substitutes

For example: A substitute in an airline industry can be video conferencing. It is very important to analyze this force keeping in mind who all can be substituted for your industry products. This is one of the reasons airline industry is declining.

Higher Threat of Substitute Products -> Low Industry Attractiveness -> Lower Levels of Profitability

#5 Rivalry Among Existing Competitors
Rivalry among competition is high when:

  • Large number of competitors (aka Low Concentration Ratios)
  • Many equally balanced competitors
  • Slow growth industry: When the growth rate is very slow one player will try to get into another player’s market which increases rivalry among them.

Note: There should never be cost rivalry in any industry. When there is a rivalry with respect to the costs then most likely the entire industry will get commoditized and will become no longer attractive industry.

  • High fixed costs & high storage costs: When these costs are high every player would like sell of his products as soon as possible and thus creating rivalry.
  • Changing conditions of demand and supply
  • Capacity added in large increments: Since exact demand capacity cannot be calculated every big player add their capacities in big increments and when it turns out that there is glut in the market as every individual did the same thing, it creates rivalry.
  • Lack of product differentiation
  • Low switching costs between rivals products: between rival incumbent players in a particular industry
  • High strategic stakes: in which you not only bring the focal industry but also other industries. For example, Kingfisher survived so long even while accumulating so heavy losses is not because of the economics associated with airline industry but because of economics of other industries he had (liquor business)
  • High exit barriers: Companies which cannot compete based on the economics should go out of the industry. For example, AirIndia is being supported by Indian Govt even though it is operated under huge losses in which case it might create rivalry with other players as AirIndia itself is not sensitive to economics whereas other players are.
  • High exit barriers are always bad.

Exit barriers are high when
· Highly specialized assets?? number of buyers
· High Fixed Cost of exit (e.g., labor agreements)
· High Strategic interrelationships
· High Emotional barriers
· High Government and social restrictions
Higher Rivalry Among Existing Competitors -> Low Industry Attractiveness -> Lower Levels of Profitability

There are two more additions to these five forces but Porter still didn’t acknowledge them into this framework.
#6 Government Actions
#7 Power of Complimentors

Industry Analysis: Putting it all together

In practical situations it would neither be on the lowest side not on the highest side but some what like this:

Note: This analysis has to be done at several stages of life cycle of a product as it varies over a period of time based on the industry.

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Repo Rate and Reverse Repo Rate

Repurchase Agreement(REPO Rate): It is the interest rate that central bank controls is called Repo Rate. It is the interest at which commercial banks can borrow from RBI up to a certain limit. This type of transaction is a collateralized transaction. In other words if the bank wants to borrow from RBI, it gives to the RBI a govt’s security. After certain period of time it purchases that same security at lower price. The difference in price is implicit interest rate which is termed as Repo Rate. Technically it is the rate at which liquidity is provided.

Reverse Repo Rate is the rate at which banks could lend to RBI.

Currently RBI sets only Repo Rate and RRR will be 100 basis points (1% less) less than the repo rate. RRR sets the floor for interest rates in the economy. (it means I cannot lend at less than RRR rate)

In between RR and RRR is Marginal Spending Facility Rate, this is 1% above RR and it is non collateralized transaction. Through this RBI has created a corridor for interest rates so that it will fluctuate within these boundaries.

Monetary Policy Implementation

Monetary policy is operated in several channels. Most important are

  • banking systems
  • financial markets
  • exchange rates

In India major monetary policy channel is banking channel, that is why India often regulates Cash Reserve Ratio(CRR).

In banking systems, leverage ratios play prominent role. More on leverage ratios is blogged under financial accounting

leverage ratio = (debt/assets)/(capital/equity)

When a bank’s equity is very low, even a small shock/recession will make the banks bankrupt.

We will discuss more about exchange rates in further posts.

Money Supply, Monetary Base, CRR and Money Multiplier

Money supply in any economy is given as ‘Currency + Deposits’

Currency is the amount of money holding by the individuals. Deposits is the money holding by the bank. Holding 100% funds in currency form by the individuals OR in deposits form in the bank is unrealistic.

In reality we use fractional banking system.

what is fractional banking system? A bank is not required to hold all the money in form of reserves, it is under the assumption that not every account holder will show up at the bank for their cash at one time.

What is Cash Reserve Ratio?: Rule is set by the central bank that at any given point of time commercial banks should hold only a certain amount(20%) of deposits as reserves.

Example:
If say, 1000 Rs is deposited into the bank, then it should keep only 200 Rs with it and lend 800 Rs to others. This will create potential transactions of worth 1800 (1000 Rs which is initially deposited and 800 Rs which is newly created), so it could create economic activity of worth 1800 Rupees. And the remaining 20% (200 Rs) is CRR Cash Reserve Ratio. Others who have received 800 Rs will now deposit that money into another bank in which again 160 Rs (20%) is retained by the bank and remaining 640 Rs is lent to others and this goes on till the deposits reach 5000 Rs. How to arrive at this deposit level of 5000 rupees? is given by CRR itself.

What is Reserve Level?: Initial amount of deposit, i.e, 1000 in above example is called reserve level.

How to compute deposit level from CRR?: Deposit Level = (Reserve Level)/CRR

Reserve level of 1000 will be able to support a deposit level of 1000/0.2 = 5000

What is Monetary Base(MB): is the initial ‘amount of capital’/’Reserve Level’ that is injected into the economy (In above example it is 1000 Rs) It is defined as ‘Currency + Reserves’

The actual amount of money supply in the economy is much higher than the monetary base (In above example it is 5000 Rs). So the Actual Money Supply is a multiple of monetary base, this multiple is called Money Multiplier  (In above example it is 5)

What determines Money Multiplier(MM)? its CRR, the higher the CRR, the lower the MM because the banks cannot indulge in multiple deposit creation.

Now if the Central Bank (CB) wants to decrease the money supply in the economy, it should raise the CRR. This is one instrument CB uses to control liquidity in the economy.

It also depends on the individual on how much to hold the money in his hands in from of currency and how much to put in bank, so central bank has only partial role to control the liquidity through CRR.

Note: CB just sets the floor of CRR but it is up to the commercial banks to decide on the maximum cap of CRR, there is no limit.

During post crisis USA federal reserve’s problem: It can increase the MB as much as it wants. When it is increased by humongous amounts then prices should go up but it is not, because banks are not lending, and instead excess reserves are going up, money multipliers are falling down and hence it is not translating into higher availability of money in the market.

Today both Europe and USA facing similar banking crisis.

1929 Banking Crisis

In 1929 crisis analysis, pattern observed was currency holdings went up and CRR also went up and as a result credit availability in the economy decreased.

Nominal and Real Cost of Capital

Cost of Capital or Discounting factor can also be termed as Weighted Average Cost of Capital (WACC)

WACC(nominal) is defined as

Cost of Capital = 
             [CoE * (Equity/Total_Capital)] +
                   [CoD * (Debt/Total_Capital) * (1-Tax_Rate)]
             OR
             [CoE*((Proportionate of Equity in Total Capital)/Total_Capital)]
                + [CoD * ((Proportionate of Debt in Total Capital) /Total_Capital)
                                                                   * (1-Tax_Rate)]
where
# CoE is Cost of Capital and CoD is Cost of Debt

If there is inflation, then WACC(real) is defined as

WACC(real) = {[WACC(nominal)/(1+inflation_rate)]-1}

Cost of Capital or Discounting Factor

‘Cost of Capital’ or Discounting Factor

There are two kinds of capital, one is loan/debt and other is equity.
How do we get discounting factor OR ‘Cost of Capital’? Here cost of debt can be known from the banks, but the cost of equity depends on the risk involved in the business. As cost of equity is not straight forward, we have to identify a mechanism to find out the cost of equity capital. Minimum cost of equity capital would be bank lending rate/government bond return (risk free rate).

Cost of Debt Capital = (Government Bond Return) + (Risk Premium for Lending)
Cost of Equity Capital = (Government Bond Return) + (Risk Premium for Investing)

Note: Government bond returns can be looked at rbi.org. Today’s  rate is 8%.

In general
Cost of Capital = (Risk Free Rate) + (Risk Premium) = RF + RP
where
# Risk Premium is a function of lending/investment instrument. For lending
      instrument RP is lower and for investment instrument RP will be higher.
# RP also depends on the risk involved in the business.

Let’s take an example (explained in our classroom):
Assume Jet Airline and Tata Power Utility companies are planning to  raise money through their bonds along with the equity investors and if investor X is planning to invest money in these companies then

Airline Power Utility
Bond 8% + ? 8% + ?
Equity 8% + ? 8% + ?

Say, investor X is interested in all the cases then, since Airline industry is more riskier than power utility business let’s assume, in Airline Bond X is expecting 4% more and in Power Utility Bond X is expecting 3% (which is nothing but risk premium on debt instrument) more than government risk free bond (i.e, 8%)

Airline Power Utility
Bond 8% + 4% 8% + 3%
Equity 8% + ? 8% + ?

Now calculate how much more X should demand on equity investment? which is nothing but risk premium on investment. How do we determine this? using Capital Asset Pricing Model CAPM, using CAPM we can calculate cost of capital.

Cost of Capital = RF* + Beta(RM-RF)
where
# RF* is the government's bond risk free rate that is taken today
  (at which point X is investing).
# Beta is a constant factor
# RM is Stock Market Return (RM) Rate
# RF is risk free rate
# (RM-RF) is historical average (not the current one)

How to find RF*? Go to http://www.rbi.org.in  On the front page itself, you will see Market Trends.  You can also use Deposit Rate or policy rates.  Place your cursor and you will find the rates.  This link also gives you good amount of information:  Database of Indian Economy RBI site has huge data and you need to patiently go through to extract the information.

RM-RF has to be sourced from two different sources.

How to find RM? RM is available in this link:  Database of Indian Economy.  You need to select:   Home + Statistics + Financial Market + Equity and Corporate Debt Market + YEARLY.

How to find RF? RF is from RBI website. Normally, it is recommended that we use about 60 years average period risk premium.  We don’t have that much of history in India and what we have is at best 30 years data.

How to get beta? You can get beta from http://www.capitaline.com but this one will work only in IIMB.  Google search will be helpful. See this one: http://in.reuters.com/finance/stocks/overview?symbol=JET.NS It looks http://in.reuters.com is useful.

What is Stock Index? It is a bench mark to invest money on safer side with minimum risk (like mutual funds). S&P is one such standard. How do we measure individual stock risk? Instead of trying to measure individual stock risk, we measure it relative to the stock index.

What does beta indicates? Beta for Jet Airways from Nifty is 1.27, which means that on a day when market raises 1% – expected returns of Jet Airways becomes 1.27% and vice versa applies when market declines.
Beta for Tata Power is 0.94

Note: If beta >1; it is more risky. If beta<1 is considered good.

Airline Power Utility
Bond 8% + 4% 8% + 3%
Equity 8% + (1.27*9%) = 19.43% 8% + (0.94*9%) = 16.46%

Now that we have cost of equity and debt capital, we can calculate the cost of capital.

Let’s say: Jet Airways company Equity of 30% and Debt 70% and Tata Power Utility company Equity of 20% and Debt 80%.

Cost of Capital = [CoE * (Equity/Total_Capital)] +
                        [CoD * (Debt/Total_Capital) * (1-Tax_Rate)]
                OR
                = [CoE*((Proportionate of Equity in Total Capital)/Total_Capital)]
                      + [CoD * ((Proportionate of Debt in Total Capital) /Total_Capital)
                                                                      * (1-Tax_Rate)]
where
# CoE is Cost of Capital and CoD is Cost of Debt

Since interests are exempted from taxes, cost of debt is multiplied by (1-tax_rate)

If we remember in previous cash flow concepts we assumed total projects are equity funded and exempted tax rates and hence we are including the taxes here in cost of debt.

From the above equations it implies that cost of capital reduces with increase in equity which means that we should go more for debt, but going for more debt involves more risk that we are taking. How do we measure the tolerance level of the risk involved in taking debts? Use optimal debt capacity

Optimal Debt Capacity: It depends on
1. Nature of the project: If the risk involved in business(technology products which outdates very soon) is high then take less risk and hence low debt. Look at the explanation from financial accounting.
2. Age of the business.

Uncertainty Costs and problems with NPVs and IRRs

What are Uncertainty Costs? uncertainty in the costs because of the instability in various factors that are considered in the project costs.

How are uncertainty costs addressed in stock markets?
In stock market there is something called ‘Call Option’. Call Option is like while buying the share we can also buy the call option of the share which implies the agreement between the buyer and the seller of the call option that if the share value goes up then buyer will get benefited from the shares, and if the share value goes down then buyer is not going to bear the loss(insulated by the call option provider)

Black Shoe Option pricing Model is one way of coming up with an algorithm to price the call option.

What is the problem with NPV or IRR? Since we assume every future number’s present value, there is some uncertainty involved the evaluation of the project costs. To address this we need to simulate the NPV/IRR for different values of ‘Cost of Uncertainties’, Cash Inflows and Cash Outflows.

Assume we simulate NPVs for thousands of times by taking different uncertainties. And from this we can form rules to find out possibilities of IRR>=15%, then we can take out all the cases in which it is meeting the criteria, etc…

This simulation is also known as Monte Carlo Simulation (MCS).

Working Capital, Cash Inflows and Cash Outflows

Working Capital

It is the minimum amount of money which is required to run the project.

In financial accounting Working Capital is

(Current Assets - Current Liabilities)
# where
# Current Assets includes cash, inventory(which includes raw material, etc)
# and account receivables.

In corporate financing, Working Capital is

[(current asset which is the minimum capital required to run the business
 + account receivables) - (account payables)]

What is Cash Outflow (COF)? it is an expense occured in all the project activities like infrastructure, salaries, land value etc. We should always avoid sunk costs such as R&D costs in cash outflows.

Note: Cash Outflows are always negative numbers.

What is sunk cost and when we should avoid them?
Sunk cost is something which is already spent and cannot be retrieved. We should always avoid sunk costs in the project costs (Cash Outflows) unless there is a value for the sunk cost in the market. For example, land value of project, R&amp;D expense of the project should not be considered in the project costs.

What is Cash Inflow? Cash Inflows can be computed in number of ways:

#1. CI = PBDIT-Tax;

#2. CI = PAT+Interest+Depreciation

Corporate Financing takes Cash Inflows a bit different from financial accounting – The factors we need to consider are:

  • We take depreciation as 0 because there is no actual cash involved in depreciation.
  • We take interest also as 0 just like we have started company with 100% equity. Even if there is actual interest we do not consider the interest.
  • Then we calculate tax separately, at the time of calculating tax, we consider depreciation.

Depreciation and Working Capital
At the start of the company/project we need to have working capital, and at the end of the project/company or after the life of the project we will get back the working capital that we initially started through salvage value of the remaining assets. Salvage value of the asset is 5% of the actual asset value.

Profitability Index and its usage

Profitability Index (PI)

What is Profitability Index? This is one of the index used to evaluate if the project is feasible to execute or not.  This is computed in two different ways

PI = (present value of cash inflow)/( present value of cash outflow)
OR
PI = NPV/COF

Decision Rule: In Method #1 accept the project if PI>1 and Method#2 accept if PI>0.

Where do we use PI? If we have limited cash where we have to select a single project and very large number of available options (with high number of projects)

Example:
Select projects subject to COF<=1000

Project    COF      NPV   IRR
     1	   300	    66	  17.2
     2	   200	   -4	  10.7
     3	   250	    43	  16.6
     4	   100	    14	  12.1
     5	   100	    7	  11.8
     6	   350	    63	  18.0
     7	   400      48	  13.5
Cash Available:    $ 1.00
Cost of Capital:     11%

Which of these projects to be selected? Apart from 2nd project other are positive hence eligible, find out values and take the projects in the descending order with sum<=1000

Payback Period and Book Returns

Payback Period (PP)

Period required to get back initial investment (adjusted for time value)
Decision Rule: Consider projects whose payback period is less than or equal to hurdle payback period
Hurdle Payback Period is some standard period defined for PP.

Book Return

It is also called as Accounting Rate of Return. This is defined as

Book Return = (Book Income)/(Book Assets)
or
ARR = (Avg PAT + Interest)/(Avg Book Value)

How is Book Income calculated? is also called as PAT.
How is Avg Book Value calculated? is the average of year after year depreciation of the initial investment.

Note: In practice it is better to avoid this value because it is easy to manipulate this value (one reason can be because of different depreciation methods).

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