Return on Invested Capital and Competi ...
Analysts forecast such things as revenues and profit margins. These things are affected by the competitive environment in which a company operates. Note that analysts base their projections on an estimate of a company’s future competitive strength.
Analysts use Michael Porter’s five forces framework to evaluate how competition will affect a company’s financial results. The framework identifies five forces that affect the competitive environment, costs, and price projections. These are:
Companies have limited pricing power if there are many substitutes in the market and the switching cost is low. On the other hand, if there are few substitutes and high switching costs, companies have greater pricing power.
Pricing power is limited in fragmented industries with limited growth, high exit barriers, high fixed costs, and identical products.
Companies whose suppliers have a greater ability to increase prices and limit the quantity of inputs face downward pressure on profitability.
Companies whose customers have a greater ability to demand lower prices or control the quantity of end products face downward pressure on profitability.
Companies in industries with low entry barriers face downward pressure on profitability. If there are high entry barriers, it is easier for incumbents to raise prices.
Besides Michael Porter’s five factors, other factors, such as government regulation and taxes, affect a company’s profitability. The best way to evaluate this is to analyze how government policies affect the five competitive forces.
Which is the following is least likely one of Michael Porter’s five forces?
- The threat of substitute products.
- Bargaining power of suppliers.
- Government regulations.
The correct answer is C.
Government regulations are among the factors that affect a company’s profitability. However, it is not one of Michael Porter’s five factors. Government regulations should be evaluated on account of how they affect the five competitive forces.
A is incorrect. The threat of substitute products is one of Michael Porter’s five forces. If there are many substitutes, a company has limited pricing power.
B is incorrect. The bargaining power of suppliers is one of Michael Porter’s five factors. Companies whose suppliers have a greater ability to increase prices and limit the quantity of inputs face downward pressure on profitability.
Reading 17: Financial Statement Modeling
LOS 17 (i) Explain how competitive factors affect prices and costs.
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