How to Analyze an Industry

You're smart to think about and evaluate an industry before thinking about and evaluating a company in it. In his book Competitive Strategy, Harvard Business School professor Michael Porter lays out five competitive forces that affect an industry.

• Threat of entry. This can be assessed by evaluating how much capital it takes to enter the industry -- the economies of scale, switching costs, and brand value. It's easier to enter the lawn-service industry than the semiconductor equipment industry -- one requires some relatively inexpensive equipment, while the other requires factories and much specialized knowledge. Switching costs protect some Internet companies, for example. People will think twice about switching from Time Warner's (NYSE: TWX) America Online to another e-mail provider because they'll have to alert too many people of their new address.
  
  
• Bargaining power of suppliers. If you're running an airline, there are only a few airplane suppliers, such as America's Boeing (NYSE: BA) and Europe's Airbus. It's more difficult in that situation to play one against the other, trying to strike a bargain. If there were many suppliers, they'd likely be competing more for your business, which might result in lower costs for you.
  
  
• Bargaining power of buyers. This is affected by brand power, switching costs, the relative volume of purchases, standardization of the product, and elasticity of demand (where demand increases as prices fall, and vice versa). In book retailing, buyers have many choices and can easily compare prices online. This gives them bargaining power.
  
  
• Availability of substitutes. If you're in the restaurant industry, your business will be affected by how easily people can buy takeout meals at supermarkets, how many people prepare meals at home, and the availability of other alternatives.
  
  
• Competitive rivalry. The more competitive an industry is, the more likely you are to have price wars and reduced profitability. The airline industry is a good example here. Over the years, it has not offered the best returns to investors.

Take these things into consideration and you may be able to zero in on the most attractive company in the industry. Alternatively, you might learn that the entire industry just isn't as attractive as you thought.

Longtime contributor Selena Maranjian owns shares of Time Warner and has flown on Boeing airplanes.