A value chain is best understood by comprehending how the various actors within an industry interact. Michael Porter was the first to popularize this concept.

Why is the concept of the value chain important?

Understanding the value chain is often the starting point for grasping industry dynamics or generating investment ideas. Without an understanding of the whole, it’s unlikely to comprehend where potential for improvement or higher profits lies.

A value chain consists of the different types of companies that exist within an industry. The simplest example is everyday consumer products (e.g., food or clothing). There, you have a value chain that looks something like this:

1. Manufacturers (creating the base product)

2. Wholesalers (large purchasers of the product)

3. Brands (selling a differentiated version of the base product)

4. Retailers (stores or online shops with customers)

Understanding a value chain is best achieved by working within an industry, working in different types of companies, and learning how it operates. This is the most common background for successful middle-aged entrepreneurs: they have gone through the entire value chain and have finally realized where something is done in an inefficient or non-profitable manner. Then they start a company that offers a better service/product specifically at that point in the value chain.

A good exercise to better understand a value chain is to break it down into components.

Two examples:

UFC/professional fighting:

1. Doctors in the ring.

2. Those who build the mats & the ring.

3. Those who make gear and training clothes, etc.

4. Coaches within the sport.

5. Dietitians and therapists, etc.

6. Those who organize the show/fights.

7. Those who market the show.

8. Those who are managers for fighters and arrange deals and matchmaking.

Music:

1. The artist.

2. Those who make the beats.

3. Studio workers, producers, and sound technicians, etc.

4. Those who make the video (choreographers, filmmakers, directors).

5. Those who are in the video (extras and dancers and actors).

Key questions related to the value chain:

– What different agents exist within this industry and how do they interact?

– What happens if one of the actors becomes larger?

– Are there complements?

– Can intermediaries be eliminated? (As in the music industry with social media, the media industry with blogs and podcasts, or the book industry with self-publishing…)

– What happens if 50% more money enters the industry? How will that money then be distributed? How will industry dynamics change?

– What would happen IF this trend/technology/purchasing behavior:

   . . . becomes 10x stronger/better?

   . . . becomes 10x more common (as the next generation is born into it)?

   . . . receives 10x more money & interest, and talent is attracted to the area?

Learn More Investing Concepts Here:

• Specialization: How one company can dominate a niche
• What is Intrinsic Value?
• How to Time Your Investments