How do you quantify threat of substitution?

Question

AcadiFi · Accepted Answer

While substitution threat is inherently forward-looking, several quantitative proxies help:

1. **Price-performance ratio trajectory**: Track how substitute's price-per-unit-of-function changes. Solar panel $/watt declined ~89% from 2010-2023 against coal power.
2. **Cross-price elasticity**: Demand response for Product A when Product B's price changes. Positive values indicate substitution.
3. **Switching costs**: Dollar cost or time investment required. Low switching costs amplify substitution risk.
4. **Adoption S-curves**: Current penetration relative to expected saturation of the substitute.
5. **Technology performance curves (Wright's law)**: Learning rate of the substitute technology.

Example: Thornhill Dairy produces fluid milk. Plant-based milk (substitute) is growing at 8.4% CAGR vs. fluid milk's -2.1%. Plant-based price premium has narrowed from 240% (2015) to 45% (2025). Cross-price elasticity estimated at +0.62. Switching cost: near zero. Plant-based market share is 18% and projected to reach 28% by 2030.

Implication: substitute threat is HIGH. Thornhill's terminal growth assumption should reflect secular decline, not GDP-plus growth. Portfolio positioning: reduce reliance on fluid milk, invest in specialty dairy (butter, cheese, protein powders) where substitution is weaker.

Substitution is particularly dangerous when it happens through improving price-performance combined with network effects from adopters (e.g., charging infrastructure for EVs accelerates substitution of ICE vehicles).

How do you quantify threat of substitution?

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