Effects of Various Factors on Pricing Power and Return on Capital

We will now look at the effects of barriers to entry, industry concentration, industry capac­ity, and market share stability on pricing power and return on capital.

Barriers to Entry

Barriers to entry are like a moat around the castle. Different industries are characterised by different barriers of entry that determine the number of entrants and the rate at which they will enter the industry. Some examples of barriers to entry are cost of capital and expertise. An industry that has low barriers of entry will attract many new players. An example of this is the restaurant business. A busy suburb is a good place for an eatery to start. Initially it does good business. Seeing the volume of business and anticipating good margins more restaurants open, the barriers of entry being fairly low. Eventually, all the business suffers. The airline manufacturing industry has very high entry barriers. The cost of capital, level of expertise and its strategic importance mean the industry has few players, not many. Companies that have high entry barriers, with all other factors being equal and are generating profits will continue to do so. From an analyst point of view such companies will keep building shareholder value. By reviewing barriers of entry an analyst can better understand the prospects of new entrants and the position of incumbent ones.

However barriers of entry being high are no guarantees to the business being successful. That requires another set of variables. In some cases despite barriers of entry being high, there are problems within the industry that do not allow for it to generate high profits.

One of the reasons is how much of a role does the price play in the customers purchase decision. For example while entry barriers to the airline manufacturing industry is high, the airline companies that buy their products are always on the lookout for bargain buys. Price of the aircraft plays a huge role, as airlines try to maximise on it, therefore reducing their overall costs, which in turn helps rope in more fliers. Fliers are always on the lookout for discount tickets and low airfare; being immune mostly to other differentiators like in-flight luxuries, ferry services, etc.

Industries with high entry barriers tend to have huge capital expenditure. They also tend to have overcapacity. The equipment and machinery used are specific to that industry and cannot be deployed elsewhere, for example, oil refineries, and aircraft manufacturers. Therefore, despite losses companies tend to keep their facilities operational. Like the entry barriers, the exit barriers are also high.

Barriers to an industry do not always stay the same. New technological innovations can suddenly lower the entry barriers to an industry. This is an important consideration for analysts while they forecast scenarios.