How To Identify a Company’s Economic Moat (Examples)
I’m relatively new to Asking Investors yet would like to talk to you today about how to identify a company’s economic Moat. Or in other words, identifying companies with strong competitive advantages.
I’ll teach you so you can easily determine if a company has a sustainable competitive advantages over its industry peers.
So, how do we identify a company’s economic moat, as well as understand how wide it is, and why is this all so important?
So what exactly is an economic moat?
While regular cash flow well managed debt and profits on the balance sheet all play a role in enduring business success. The ability to develop a wide economic moat is the key to what separates the winners from the losers over the long term.
What we referred to as a moat is what other people might call competitive advantage.
It’s something that differentiates a company from its nearest competitors, in very simple words: an economic moat is basically anything that gives a business some form of built in protection for its ongoing generation of cash flow.
If you picture a company as a castle that is constantly under attack by its enemies, or competitors, you’ll have a better understanding of just how important an economic moat is. It helps a business to thrive and survive in the marketplace.
And here’s what you should keep in mind when evaluating a company. Without one or more protective Moat’s firmly in place, a formerly profitable business will soon find itself unable to maintain its market share and its revenues will begin to drop off.
This also means that a company without a unique economic moat can’t survive in the long term.
It will be harder for it to compete with other companies within the same industry and it will be harder for direct cover for market downturns recessions or financial disasters.
Remember that a competitive advantage is essentially any factor that allows a company to provide goods or services that are similar to those offered by its competitors. And at the same time outperform those competitors and profits.
So the easiest way to determine the size of a company’s economic moat is look at its historical operating performance to evaluate a company’s operating performance.
You can use some profitability and efficiency ratios.
Then you can compare its ratio values with that of its competitors and the industry average.
If the company you’re evaluating maintains a better and more efficient operating performance than its competitors it’s clearly the winner.
And you can expect that it will survive in the next decades.
Now, I’ll give you a complete list of economic moats that a company may have.
And I’ll also talk a little further about economic moats and why they’re so crucially important in value investing.
The concept of the economic moat comes from Warren Buffett. He evaluates a company’s economic Moat’s to determine its ability to maintain a competitive advantage over its rivals and thus protect its long term profitability and market share.
So why do companies need a competitive advantage? A competitive advantage as any quality that enables a company to offer similar products to its peers while enjoying superior financial performance over time.
Companies are more likely to lose their competitive advantage, because as they grow increasingly profitable competitors are more likely to replicate their methods or create even better ones.
As soon as the level of a company’s profits is significant enough to warrant attention, it opens itself up to attack from competitors who are looking to enter the marketplace… with the intention of grabbing a share of those profits for themselves.
This is exactly where a wide economic mode offers the protective barrier.
A business needs to prevent other companies from stealing its earnings, or in other words establishing economic Moat’s can help companies protect their long term profits.
In reality an economic moat serves as a competitive advantage over other companies within the same industry.
But what sets it apart is the fact that the advantage is sustainable over a very long period of time.
While these moats can be created in a number of different ways, it may be either narrow or significantly wide.
It only stands to reason that the more of them a business can build the better off it will be.
Let me ask you a quick question.
How can you feel confident about estimating a company’s ability to generate earnings down the road?
If that ability is not protected in some way – and you know the sustainability is the key to consistent and ever growing revenues – then the economic moat is the key to that sustainability.
While having a competitive advantage may allow business to temporarily outperform its competitors. The economic moat is a benefit that’s built to last and it will ultimately determine whether a company is set up for prolonged success or inevitable failure from an investment point of view.
The longer companies economic moat can hold firm. The longer you will benefit from its profits.
It’s important to be aware that there are some false business Moat’s in the marketplace masquerading as the real thing, and you should be careful not to be taken in by these impostors features.
Things like superior products, outstanding marketing strategies, and high performance management teams are all wonderful attributes for a business to have… But on their own they are not enough to provide a long term competitive advantage.
Products or marketing tactics can easily be copied and so require the presence of a deeper more durable barrier to support and protect them from would be thieves.
So make sure that you’ll only invest in companies with moats that generate superior shareholder returns over the long run. By doing this you should also be extremely selective and focused on wide moat stocks.
Although economic moats tend to be more qualitative than quantitative in nature, there are a number of ways you can recognize when a company has one or more moats in place. A significant amount of cash flow, and a strong operating performance are common to all businesses with an effective economic moat.