Fundamental analysisModule 1, lesson 2 of 48
Industry analysis and competitive positioning
How industry structure, barriers to entry, the power of customers and suppliers, and substitutes shape the profits every company in an industry can earn.
In this lesson
- Describe an industry's structure, from many small competitors to a few large ones.
- Assess barriers to entry, the bargaining power of customers and suppliers, and the threat of substitutes.
- Explain why a fast-growing industry can still give poor returns.
- Place a company within its industry and judge its relative position.
Builds on
- Understanding a company's business modelYou need to know what a company sells and to whom before you can analyse the industry it competes in.
On this page
In simple terms
A company does not earn profits in isolation. It competes with rivals, buys from suppliers, sells to customers who can go elsewhere, and faces the risk of being replaced by something new. The way these forces play out in an industry sets the range of profits every company in it can earn.
That is why fundamental analysis looks at the industry before the company. A well-run company in an industry where everyone sells the same thing on price may earn thin margins for decades. An ordinary company in an industry with strong barriers can do well for a long time.
Industry structure
Start with how many competitors there are and how big they are.
- Many small competitors, selling similar products: competition is usually intense and margins thin. Examples include many trading, transport and basic manufacturing businesses.
- A few large competitors: competition can be more restrained, though price wars still happen when demand falls or one firm wants market share.
- One dominant company: profits can be high, but such positions attract regulators and new entrants.
Market share and how it is changing tell you whether a company is winning or losing within that structure.
The five pressures on profit
A widely used framework, popularised by the economist Michael Porter, groups the pressures on an industry's profits into five forces.
| Force | Profits are lower when... |
|---|---|
| Rivalry among existing competitors | There are many similar competitors, the product is the same whoever makes it, growth is slow, and fixed costs are high, so firms cut prices to fill capacity |
| Threat of new entrants | Starting up is cheap, no licence is needed, and customers have no loyalty |
| Bargaining power of customers | A few large buyers take most of the output, or customers can switch suppliers easily |
| Bargaining power of suppliers | A key input comes from a few suppliers, or only one |
| Threat of substitutes | A different product or technology can meet the same need |
Barriers to entry
Barriers to entry are what stop new competitors from arriving when an industry is profitable. They include:
- Scale: a new entrant must spend heavily before it can match incumbents' costs, as in steel or telecom networks.
- Licences and regulation: banking, insurance and some utilities need permission to operate.
- Brands and distribution: years of advertising and a network of shops or dealers are hard to copy quickly.
- Technology and know-how: patents, specialised processes or skilled teams.
- Switching costs for customers, covered in the competitive advantage lesson.
Where barriers are low, high profits do not last. New firms arrive, add capacity and cut prices until returns fall to ordinary levels.
Growth is not the same as profit
It is natural to look for fast-growing industries. But growth and profitability are different things. A growing industry attracts new entrants and new capacity, and if barriers are low, the extra supply can grow faster than demand.
Worked example: Two made-up industries
Compare two made-up industries over ten years.
| Industry A: budget furniture | Industry B: specialised valves | |
|---|---|---|
| Demand growth | 15% a year | 5% a year |
| New competitors | Many, cheap to start | Few; years of testing and certification needed |
| Customers | Price-sensitive shoppers who switch easily | Plants that rarely change a proven supplier |
| Typical operating margin | 4% | 18% |
Industry A grew three times as fast, but its companies earned thin margins because competition kept prices low. Industry B grew slowly, but barriers and loyal customers protected its margins. An investor who chose by growth alone would have picked the weaker industry.
Airlines are a frequently cited real-world illustration: in many countries passenger numbers have grown enormously over decades, while airlines have often struggled to earn good returns, because of intense competition, high fixed costs and powerful suppliers of aircraft and fuel.
Placing the company in its industry
Once you understand the industry, compare the company with its competitors.
- Margins: are its gross and operating margins higher or lower than peers', and why?
- Market share: is it gaining or losing share?
- Costs: does it have a cost advantage from scale, location or technology?
- Customers: does it sell to the same customers as peers, or to a better-paying niche?
A company with consistently higher margins than its peers may have a real advantage, which the next lesson explores. One with lower margins needs a reason to expect improvement.
Why it matters
Industry structure is one of the most reliable guides to long-run profitability. It explains why some companies earn high returns for decades while others, equally well run, never do. It also helps you spot when an industry's economics are changing, for example when a new technology lowers barriers, or consolidation reduces rivalry.
Limitations
Industry boundaries are not always clear: a company may compete in several industries, and new technologies can redraw them. The five forces describe pressures, not precise outcomes, and judgements about them are qualitative. Industries also change over time, so an analysis must be revisited.
Common mistakes
- Choosing industries by growth alone. Growth without barriers attracts competition.
- Ignoring customers' and suppliers' power. A company squeezed from both sides earns little whatever its sales.
- Comparing a company's margins with the wrong peers. Compare with businesses that sell to the same customers in the same way.
- Assuming today's structure is permanent. New entrants and substitutes can change an industry quickly.
Try it yourself
Choose an industry you know as a customer, such as mobile phone services, paint, cement or airlines.
- List the main competitors and roughly how much of the market each has.
- For each of the five forces, write whether it is strong or weak in this industry and why.
- Find two listed companies in the industry and compare their operating margins over several years from their annual reports.
- Write one sentence explaining any difference you find.
Key takeaways
- The industry a company competes in sets the range of profits it can hope to earn. A good company in a brutal industry often struggles.
- Five pressures shape an industry's profits. Rivalry among competitors, the threat of new entrants, the bargaining power of customers, the bargaining power of suppliers, and substitutes.
- High barriers to entry protect profits; low barriers invite competitors who bid profits away.
- Industry growth does not guarantee good returns. Growth attracts new capacity and competition.
- Compare a company's margins and returns with its competitors' to see where it stands.
Check your understanding
Finished reading?
Your progress is saved only in this browser.
Terms used in this lesson
- Barriers to entry
- Whatever makes it hard for new competitors to enter an industry, such as scale, licences, brands, distribution networks or technology.
- Pricing power
- A company's ability to raise prices without losing many customers, one of the clearest signs of a competitive advantage.
- Business model
- How a company turns what it does into money, covering what it sells, who pays, how it reaches customers and what it costs to provide.
- Gross margin
- Gross profit as a percentage of revenue. It reflects how much a company earns over the direct cost of what it sells.
Spotted a mistake or something unclear? Report it by email. Here is how corrections work.
This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.