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.

Industry Concentration

Industry concentration refers to the number of players in an industry. A low number of players in an industry do not automatically mean high margins.

Industry concentration analysis starts with market share analysis. The market share of each player in the industry in both absolute and relative terms must be studied. The market size is also an important factor. A market share of two to three percent may seem relatively small but if the market size is large, this in fact represents a very lucrative share.

In a concentrated industry, all players are aware of what strategy the other is using. It may lead to a cartel like situation where prices are fixed. Alternatively, players of such an industry may understand the unwiseness of a price war, thus maintaining the status quo of revenue and profit.

Fragmented industries tend to have lower margin and the profits broken between them. Since the number of players is numerous, price wars ensue and value gets eroded.

Industry Capacity

If an industry maintains a strict balance between the supply of and demand for its products, it stands to gain. The opposite is also true. Overcapacity will tend to reduce the ability to get a good price. An analyst will look at how an industry and its participants manage capacity. Do they respond quickly to fluctuations in demand? Can they step up supply when demand shoots up? How long will it take to add capacity when there is a shift in demand? What would be the capital expenditure to expand capacity? What would the company do in times of overcapacity and low demand?

In the event of a natural calamity the demand for goods and services may increase. An analyst would need to project realistic scenarios. It is always easier to increase capacity for services than for industries with heavy capital expenditure requirements.

Market Share Stability

Companies with stable market shares indicate a less competitive market. Unstable market shares indicate a far more competitive market. If the switching costs in an industry are low as are newer cheaper innovations then the market share stability is unlikely to be stable. Markets characterised by high switching costs and low level of innovation in addition to low entry barriers tend to be very unstable.

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