the company

Before considering any company as a possible investment, it’s smart to study its industry. In his book “Competitive Strategy” (Free Press, $37.50), Harvard Business School professor Michael Porter laid out five competitive forces that affect an industry.

•Threat of entry. Evaluate 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 companies, too. People will think twice about switching e-mail providers because they’ll have to alert too many people of their new address.

• Bargaining power of suppliers. There are only a few airplane suppliers (such as Boeing and Airbus), so if you’re running an airline it’s difficult 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). When buying electronics, for example, consumers have many choices and can compare many 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.

Consider factors such as these, and you might learn that an industry just isn’t as attractive as you thought. Get more investing insights in “The Future for Investors” by Jeremy J. Siegel (Crown Business, $27.50).

Ask the Fool

Q: When one company buys out another and spends, say, a billion dollars to do so, who actually gets that money? Where does it go? — Beverly Wolf, Richmond, Calif.

A: If the acquiring company pays cash, it goes to the shareholders of the acquired firm. There are also payments to other classes of equity, the preferred classes (think preferred stock). On some occasions, some of the cash tendered may go to debt holders, if part of the purchase price is allocated to buying back debt.

If the acquirer buys with its own stock, then shareholders of the acquired firm will get shares of the acquiring company in exchange for their acquired-firm stock. These shares can be sold for cash, or the shareholders can simply hold on. Companies typically buy other companies for more than their pre-purchase market price — they pay a “premium.”

Some purchases involve combinations of cash and stock. In all-stock transactions, no cash trades hands.

Q: Who exactly sets the price for stocks? — Larry W., Union, Ky.

A: A company’s stock price is not set by any person or even by the company itself. Rather, once shares have been sold by the company to the public (either via an initial public offering or a secondary offering), they trade fairly freely in the stock market.

Think of the market for collectible comic books. A comic book is valued at what people will pay for it. If demand falls, the price will, too, and vice versa. That’s why, if there’s very bad news about a company, its stock will quickly be worth less, and when there’s good news, the stock is often seen as more valuable. Learn more at www.fool.com/school.htm.

My dumbest investment

Of all the stocks I had, only one was doing well. I sold everything and put it all on that one. Maybe that was dumb, but I managed to make back all my losses by doing it. What was really dumb was calling my broker and telling him to put everything on this one stock. I didn’t realize he would include my margin account, investing as much as I could borrow from the brokerage! I received a margin call the very next day when the stock went down just enough to require it. Luckily, I sold enough to cover that screw-up, and the stock still made up my original investment. Here’s another scary thing: The day after I finally took all my money out, the stock dropped like a rock. Had I waited one more day, I wouldn’t have had even half of my original investment! — Brian Daniels, Garden Grove, Calif.

The Fool responds: You were lucky to get out alive from this. It’s extremely risky to put all your eggs in one basket.