2. The following deck conveys key course
concepts. The goal of this handout is
to you can identify points I can clarify
in class. We will do some in class
group work as a way to identify
concepts to clarify.
3. All Companies Belong to An Industry, and All Industries are Part of a Value
Chain. The Top of the Chain are Key Inputs and the Bottom of the Chain are
Businesses Closer to the End Customer -- Distributors and After Sales
Service Providers—Here is the Value Chain for Personal Computers…
Equipment Materials Components
Product
Design
Assembly
Operating
System
Application
Software
Sales &
Distribution
Field Service
Suppliers of
equipment and
software for
production of
semiconductor
chips for
hardware
Mining, raw
materials and
advanced
materials for
manufacturing
CPUs, DRAMS IBM, Compaq,
Dell
Compaq, Dell,
and eventually
contract
assemblers
Microsoft Microsoft Dell, Micro
Center, Best Buy,
Apple
The following questions are useful for understanding the relative attractiveness of stages (or industries along) the value
chain. These questions are also useful to determine (conceptually) how a firm can be well positioned within its stage of the
value chain and whether operating in multiple stages would improve the company’s position in its market (i.e., Why should
Tesla make its own batteries?)
- Where along the value chain is the potential for defendable “scarcity value” and why? The market attributes and
conditions listed on the next slide address this question.
- What is the market structure of each stage? The more fragmented the market, the lower the potential for enterprise
value.
- Why might participating in multiple stages of the value chain improve a company’s position (and its net enterprise
value)?
The guy who
had Hunter’s
laptop
4. Our Course Framework:
1. How good is the company’s vantage point ? The company’s vantage point is a combination of
how attractive is the industry in which it competes AND how well positioned or how “added
value” is the company relative to its costs and competitors.
1. Implementation: How does the company’s corporate scope (degree of vertical integration,
horizontal scale and diversification) contribute to enterprise value? What market opportunities
or constraints does the company exploit or neutralize through its implementation (its
dimensions of scale and scope)? What constraints on enterprise value are difficult to address?
2. Governance or Culture: How well does the company’s governance drive alignment internally
(culture) and among itself and its key trading partners?
Porter’s 5 forces -- on net,
how attractive is the
industry?
Unattractive
Attractive
How sustainably added value
(profitable) is the company?
Well Positioned Poorly Positioned
As you deepen your understanding of the value of a
company, keep these high level benchmarks in mind:
• 20% of company value is explained by industry
attractiveness
• 33% of value is explained by its market position a
company’s position is often summed up with answers to
the questions what product, to whom and at what price?
• And the rest of the value is explained by more granular
company specific factors such as implementation and
governance (management quality)
5. 8/29/22 5
Porter’s Five Forces:
• Threat of entry
• Indirect rivalry from substitutes
• Direct rivalry from competitors
in your market
• Bargaining power of buyers
• Bargaining power of suppliers
Here is a Comprehensive List of Factors for Identifying the Opportunities
and Constraints a Firm Faces in Its Market/Industry/Business Sector
Basic or general market conditions
-Taste/demographics factors
-Technological conditions
-Regulatory enviornment
-Cost of capital
-State of global trade
Drivers of Market Structure: How concentrated vs fragmented are
market (industry) revenues? What share of revenues do, say, the 3
largest firms earn? Some factors that affect market structure are:
- Demand growth and how rapidly tastes (WTP drivers) change
- Level of fixed cost & shapes of variable and average cost curves
- Price sensitivity (elasticity of demand)
- Concentration (structure) of upstream (supplier) and downstream
(buyer) markets
- Transaction characteristics—ease of verifying quality, legal recourse,
etc.
- Capacity utilization patterns—i.e. boom and bust (summer resorts)
- Legacy effects—Coke’s availability during WW2
- Unique or one of a kind assets—location, specific talent, URLs
6. The Five Forces Identifies Bargaining Power Along an Industry Value Chain
An Attractive Industry is One that Does NOT Face Much Bargaining Power
Rivalry is more likely the more fungible (indistinguishable) is the
output among firms in the industry (i.e. no brand loyalty) and
when firms cannot observe each other’s prices. Excess sunk
capacity means the industry can supply more of the good/service
than is demanded at prices high enough to generate economic
profits. Excess capacity provokes rivalry as each firm is
motivated to lower price and/or increase features to recoup as
much of their average cost as possible. Rivalry is profit reducing
when there isn’t enough demand for the industry to set price ≥
average unit cost.
Substitutes are industries that “sandwich” the industry. They
are threatening when customers get more surplus (WTP-P)
from them – when customer demand is price elastic:
• Is the substitute a lot better and only a little more
expensive? It ”attacks” from above.
• Or is the substitute a lot cheaper and only a little worse? It
”attacks” from below.
• Better + Cheaper This is beyond substitution, it is
obsolescence! Obsolescence is “game over”-- its A LOT
worse than threats from substitutes because there isn’t
necessarily a way to respond.
Entry occurs when the risk of entry is small relative to the opportunity open for the
entrant. Entrants are attracted by the potential to get market share high enough to
compensate for the costs and risks of entry ( NPVEntry > 0). Significant early mover
advantages (such as better locations, reputational capital) discourage entry.
Suppliers may have power when their stage of the industry
value chain
• Is more concentrated than is the industry and they…
• Contribute a high share of the benefit derived from the good
or service from the point of view of industry’s buyers (that is,
the industry’s buyers or end customers’ WTP is, in good part,
caused by the suppliers input).
• Requires that firms in the industry (being analyzed) make
relationship specific investments
Buyers: What factors or conditions cause buyers to have bargaining power or
potential added value? When the…
• Buyer’s industry is relatively more concentrated than the industry being
evaluated. i.e., An industry with 5 competitors may face buyer power if it
sells to an industry with only 2 competitors.
• Firms in the industry need to make relationship specific investments to work
with buyers
• Buyers can backward integrate and supply themselves
• Industry’s output is a high share of the buyer’s costs. Why does this matter?
Note: End consumers (individual shoppers vs. businesses as buyers) are unlikely
to have buyer power – why? Because individual shoppers each represent too
small of a share of the industry’s (or any one firm’s) sales to matter enough to
have power. Be sure you do not confuse buyer power with rivalry!
7. A Taxonomy of Market Structures
Returns
to
Size
Nature of Market (Where on the Pyramid?)
Low
Returns
High
Returns
Demand is Also Internally
Driven—These Goods are Wants
Perfectly
Competitive:
Undifferentiated +
No returns to scale
Oligopolies: Economies of
scale/network effects)
Examples: Industrial
chemicals, consumer
packaged goods, branded
apparel, fast food
Monopolistically
Competitive:
Consumer taste is
heterogeneous, scale
requirements are low i.e.
gourmet restaurants
Demand is Mainly
Externally Driven – These
Goods are Needs
“Natural” Monopolies:
Examples: Utilities, public
goods, national defense
“Winner Take All” or Platform Businesses
Examples: Google, Facebook
8. Maslow’s Hierarchy of Needs
Lower on the hierarchy, firms tend to
compete on attributes such as location
and verifiable quality attributes and,
ultimately on price.
Higher on the hierarchy, firms compete on
objective but also on many subjective
attributes that drive WTP among some but
not necessarily all customers.
9. The Structure of the Market in Which a Firm Competes Affects Potential Enterprise Value
Competitive Undifferentiated Oligopoly Natural
Monopoly
Monopolistic Competitive (Small scale
but differentiated)
Differentiated Oligopoly Winner Take All
Example: NYC Deli’s, corner markets, jewelers
on 47th street
Specialty chemicals Utilities Beauty salons, florists, boutiques Consumer packaged goods, LVMH Web search, PC operating
systems, OTAs
What is the
competitive
environment like?
Many small competitors who are, at
best, weakly differentiated. Often more
“added value” happens above or below
this industry (suppliers or buyers). For
example, the inputs the deli uses
(brand of cold cuts) may matter more
to customers than the deli itself.
Jewelers in a jewelry or diamond
district of a large city depend on
certification by the GIA to confirm how
good is their merchandise.
A few competitors whose profitability is based on
industry capacity (supply) vs. market demand.
Firm advantage is likely based on defendable cost
advantage and advantaged geographic access to
many customers. Market share can shift rapidly to
a more efficient firm with (i.e.) better technology.
Little competition
but often
regulated.
Subject to
environmental
and political
factors. Can be
made obsolete
by new
technologies or
regulatory shifts.
Monopolistic competitors are differentiated
but they have relatively small market
shares. In this structure, there are many
distinct customer segments. Monopolistic
competitors exhibit a big range in
profitability--but even the profitable firms
face a ceiling on enterprise value due to
their limited economies of scale/scope,
generally high customer acquisition and
retention costs and lower barriers to entry.
A few competitors whose profitability is
primarily based on their degree of
differentiation and the size of their
addressable market. Overall market
supply + demand and the firm’s relative
production efficiency are also key. While
the cost of innovation can be spread over
the company’s share of the market, in
some differentiated oligopolies, innovation
= 10-20% of net income. Net profitability
depends on the firm’s innovation hit rate.
WTA market means (1)
Strong network effects (2)
High “multi-homing” costs
(3) Weak demand for
differentiation. Convergence
may be preceded by a “War
of Attrition”, which is fought
with financial and human
capital in which competitors
suffer losses before a victor
eventually emerges.
Why do earnings
vary among
competitors?
Variance due to:
• Relative operational efficiency
• Differences in demographic,
economic and other attributes of the
customer/geographic market served
Strategies:
• Is there an opportunity to invest in
size and move into a better market
structure? i.e., Is it possible to
supply to the competitive industry a
key WTP or C driver? Move up
toward oligopoly.
• Move up the pyramid from a utility to
a want (add value from a perspective
of an attractive customer segment to
serve) – not increasing scale but
increasing margin. Move from the
competitive structure to monopolistic
competitive – no scale but at least be
differentiated.
Variance due to:
• Differences in costs which may be tied to timing
of investments in production capacity—so (quite
frankly) luck.
• Demographic, economic and other attributes that
range among geographic markets served.
• Being more “just in time” if inventory holding is
costly
• Skill of CFO--taxes, hedging, cost of capital
matter.
Strategies:
• Exceptional operational efficiency in one or a few
stages of the company’s value chain may be
enough to generate advantage.
• Forecasting demand is sometimes the key –
investments that improve the firm’s information
on costs and market demand
• Firms with better customers, operations and/or
revenue models can earn higher returns.
• In sum, investments in relationship capital and
infrastructure that contribute to production
efficiency and lower transactions cost.
Dominant firm
has cost-side
scale economies
and is often
protected or
affected by
regulations.
Variance due to:
• Demographic and economic differences
among target customers
• How satisfied are customers with the
firm’s output (how close to the customer
“ideal” is the company’s offering?)
• The firm’s relative operational efficiency
Strategies:
• Invest in “signals” of quality to drive
customer retention and acquisition.
• Leverage product superiority and
signals that reduce customer acquisition
costs by adding products and/or expand
into additional geographies.
Variance due to:
• Demographics, economics and other
attributes of market segments served.
• Defendable brand equity can
accumulate over time
• Innovative capacity – high innovation hit
rate.
• Superior distribution reinforces brand
perception.
• Superior operational efficiency is (as
always) valuable.
Strategies:
• Investments in innovative capacity to
maintain position as the top competitor
or among the top few
• Attraction and retention of talent
• Observable or quantifiable “signals” of
quality.
• Infrastructure investments that both
amplify the productivity of key talent
employed and that directly or indirectly
benefit customers.
The winner likely had one
or more of the following:
ability to move quickly,
strong brand equity, existing
IP to leverage, and/or ability
to offer complementary
products
On net, the winner had the
benefit of some asymmetry
that increased the firm’s
ability to prevail.
