stockpro Economic moats enable a company to earn oversized profits over time through a competitive advantage
that lasts for a long time. A company that rewards investors over the long term has a durable
competitive advantage, according to Warren Buffett, one of our favorite investors of all time. To figure
out what kind of advantage a company has, we need to understand what kind of defenses it has built for
itself in its industry.
An investor needs to consider moats because the moment a company develops a useful product or
service, it doesn’t take long for other companies to attempt to capitalize on that opportunity by creating
a similar–if not better–product. According to basic economic theory, any excess profits earned by a
successful company will eventually be eaten by competitors. Due to competition, it is difficult for most
firms to generate strong growth and profitability over an extended period since any advantage is always
subject to imitation.
Whether a company can prevent its competitors from taking away its business or eroding its earnings
will be determined by the strength and sustainability of its economic moat. While we consider
companies with wide economic moats to be best positioned to retain customers over the long run, the
terms “narrow” and “none” are also used to refer to a company’s moat. We are not accustomed to
talking about how deep a moat is, but it provides a useful way to think about how much money a
company can make leveraging its advantage.
If you want to determine whether an organization has an economic moat, follow these steps:
- Determine the company’s profitability in the past:
Have the firm’s assets and shareholder equity generated a solid return? When determining whether a
company has a moat, this is probably the most significant factor. Moat assessment is mostly qualitative,
but solid financial metrics remain the cornerstone of any analysis of a company. - The firm must have a steady profit and a solid return on capital:
To identify the source of this profit, you must identify how that profit is generated. Can other companies
easily imitate the source, or is it an advantage that only this company has? As difficult as it is for a rival
to copy an advantage, the more likely a company is to have a barrier and a source of economic profit. - Calculate how long the company will be able to hold off its competitors:
During this period, we refer to the firm as having a competitive advantage, and the period can last as
little as several months or as long as several decades. As a result, the economic moat grows wider with
the period of competitive advantage. - Consider the competitive landscape of the industry:
What percentage of its firms are profitable, or is it hyper-competitive with a few companies scrounging
for every dollar? Industry sectors with high levels of competition will typically have lower profits over
time.
What is the importance of understanding economic moats before investing?
A wide-moat stock at an underpriced value is the best investment for a valued investor. Identifying
companies with economic moats is important before making investment decisions. To find the economic
moat in the financial reports, you must look at the following points:
1. An increase in overall sales.
2. Increase in revenue and profit.
3. ROE and ROCE are both ways of enhancing profitability.
4. Along with the financial report, it would be wise to examine the market sentiment in its entirety.
5. Look for brands that have gained a reputation in the market for their quality products and
services.
6. Profitable companies with a good reputation in the market have a high level of reliability.
Takeaways
7. Choose companies with an economic moat if you are investing for the long term.
8. These companies tend to be more profitable over time.
9. To know the market condition of a company at any given time, financial reports of the company
should be followed regularly.
10. Along with the financial reports, a company’s overall brand reputation should also be observed.
Economic Moats: Why are they Important?
A moat of economic importance ensures the profitability of a company in the long run. Before investing
in a company’s stock, investors should analyze the company’s economic moats. Warren Buffett says that
a company with an economic moat can remain competitive regardless of market conditions. A company
that has an economic moat has a competitive advantage. By creating an economic moat, a business can
gain market sustainability for a long time.
What are the signs of moat companies? 1. Company size and constant profitability are the two main screening criteria. 2. Financial reports generally show ROE and RoCe as a measure of a company's profitability. 3. Market capitalization and sales revenue are also affected by the size of the company. Sources of Economic Moats: When a company maintains low operating expenses compared to its peers, it can retain its competitive edge by lowering prices and keeping rivals at bay. It can be hard for competitors to duplicate Wal-Mart Stores Inc.'s low-cost products in its stores since Wal-Mart negotiates low prices with its suppliers. Patents, brands, and licenses are intangible assets that allow companies to charge premium prices and protect their production processes. Companies obtain patents by filing with the government for ten years or more to protect their know-how, while brands typically develop from superior product offerings and marketing. After spending billions on research and development, pharmaceutical companies earn high profits from patented drugs.
