How To Identify Moat Companies – Having Strong Competitive Advantage

By Trader Pit

May 31, 2021


Moat companies have long been an attractive investment for investors. Moat companies are those that show a higher return on investment than their peers. The theory of moat companies is simple: people will pay more for something than a similar product, if the service or product provides a benefit that people cannot get elsewhere.

Few things are more valuable to an investor than the ability to single out a company that has a moat, or a competitive advantage over rivals. Moats are the primary reasons why great companies such as Google, Costco, and Disney are able to prosper through years of growth. This post will demonstrate how to identify moat companies by using the company’s stock price and its return on capital, or its ROIC, to measure its competitive advantage.

Moat is an important factor in the growth of any company. This factor is also called “competitive advantage”, “lock-in” and “intangible advantage”. As a result, the Internet is now full of investment advice that tells you to find companies with strong competitive advantages. So how can you find these companies? The answer is simple: study moat.. Read more about list of wide moat stocks and let us know what you think. In our series on stock market fundamentals, we talked about a company’s economic space. A larger gap gives the company an advantage over its competitors. These companies operate on high margins. But how do you identify mobile home businesses? In our previous article, we mainly talked about the qualitative factors that give companies moats. However, you can also identify RV companies by looking at their financial results. In this paper, we will attempt to find a way to quantify a set of parameters that indicate a ditch society.

Peer identification parameters

word-image-4588 Warren Buffett likes companies that have strong competitive advantages. He has his own way of identifying such a company. But how can we, as laymen, identify companies with an economic moat? The economic moat gives the company three visible advantages. Based on these three advantages, experts have formulated rules for identifying gap companies. What are the three advantages?

  • Fields: High margins are one of the first characteristics of an economically disadvantaged company. In one industry, the company will have a significantly higher profit margin than its competitors. Read more.
  • Turnover : A situation can arise when the industry itself is too competitive. Companies in this sector cannot show high profitability. But companies in this sector will have higher turnover. Also read.
  • He’s coming back: A company with an economic moat has high margins or higher sales or a combination of both. These two factors result in a higher return on capital. Read more.

#1 Fields

For a company, margin can be expressed in the form of net profit (PAT). However, a more effective measure would be free cash flow (FCF). Moat companies have an uncanny ability to generate higher margins than their competitors. Let’s learn more about FCF and PAT efficiencies for a typical bar steel company.

#1.1 Free cash flow return

word-image-4589 Companies with an economic advantage generate above-average free cash flow (FCF). This is a typical feature of all excavation companies. But investors should pay attention to what FCF is. This is the cash flow generated by the company’s operations, net of CAPEX. What is CAPEX? Money used for capacity expansion (purchase of new fixed assets). Net cash flows from operating activities and CAPEX are available in the company’s statement of cash flows. So how do you determine if the generated free cash flow (FCF) is sufficient or not? What should be the typical value of a moored business? We need to express FCF as a percentage of sales (FCF yield = FCF / sales). As a general rule, an FCF return of more than 5% is considered good. But check this value for the last 5 to 10 consecutive years. A consistent FCF performance of 5% or more means you’ve found a great company.

#1.2 Net profit margin (NPM)

word-image-4590 PAT margin is a way of expressing the profitability of a business. A company that generates more PAT per rupee of revenue is a good company. How do you generate more PAT per rupee in revenue compared to the competition? To do this, a company must have two advantages:

  • Low cost: A company that can produce similar products at a lower price has an advantage. This benefit can be achieved in several ways. Either the company has low overhead costs or it buys cheaper raw materials.
  • Achievement Awards: The company can sell the same product at a higher price. How do you do that? Because of the price point. Quality products from a well-known brand have a price advantage over the competition.

Thus, a company with the above two advantages will have a higher return. How do you know if the net margin is high or not? We need to express PAT as a percentage of sales (net margin = PAT / sales). As a general rule, a net margin in excess of 15% is considered good. But what would be even better is consistency over 5 years or more. But it is also true that a company that does not operate at higher margins can still generate higher net profits. How do you do that? We know that when we talk about the DuPont formula. According to experts, an investor should always consider net margin and income as one. The DuPont formula can give us that view.

#2. Turnover

word-image-4591 Companies buy equipment to expand their operational capabilities, which drives revenue growth. But it is not enough to guarantee sales, it is also necessary to ensure that they are efficient. To understand this, let’s take a hypothetical example. Suppose two companies are active in the information technology and metalworking sectors. Their turnover rate (= sales / total assets) is shown in the following infographic. word-image-4592 The company’s turnover in the IT sector is higher than in the steel sector. This means that an IT company can generate more revenue per unit of equipment. You can see that the asset turnover of an IT company is systematically higher than one (1). However, it is not meaningful to compare the turnover of assets of two companies operating in different sectors. To get a more complete picture, we need to compare asset turnover of companies in the same industry. Example: word-image-4593 In general, a company with a turnover rate of 0.67 is considered good. A turnover rate greater than one (1) is the same as striving for perfection. This does not mean that all companies with low asset turnover (less than 1) are bad. First, we should not compare the turnover of assets in different sectors. Second, the combined effect of asset turnover and industry margins is more important. We will learn more about this when we discuss the DuPont formula.

#3. Back

When we talk about profitability, we mean the profitability of the company. RV companies are more profitable than their competitors. Two parameters we can use to measure the profitability of a company. First, the return on equity (ROE). Return on equity measures the profitability of a company in relation to its equity. In the formula, ROE = net income / equity. The second measure we can use is called return on assets (ROA). It measures the profitability of a company in relation to its total assets. In terms of the formula, ROA = net income / total assets. To better understand ROE and ROA, consider this formula: word-image-4594 So we can say that when we measure return on equity, we only look at the equity (which is part of the assets). But to calculate ROA, we take all assets into account. So how do you know if a company’s ROE and ROA are good or not? In general, RV firms have ROEs greater than 15% and ROAs greater than 10%. But the company must present these indicators consistently for at least 5 to 10 years. word-image-4595

Understanding ROA and ROE using the Dupont equation

The Dupont equation is another way of looking at the ROE formula. This equation distinguishes and highlights the most important factors for return on equity. Return on equity, expressed as a Dupont equation, tells investors what a company is doing right or wrong to achieve profitability.

#3.1 Formula for Calculating Return on Invested Capital

But before we look at Dupont’s comparison, we need to understand his analogy to ROA. The ROA formula, expressed as a Dupont equation, can be represented as follows: word-image-4596 What does that mean? Ideally, a moat company has a high net margin. The company will also be in a better position to transfer its assets for sale. Such a company is considered more productive, and therefore has a higher return on investment. Using our rule of thumb described in sections 1 and 2 above, we can assume that an ROA of 10% or more is ideal for the company. Check the formula above. Quick tip: The next time we see an action with a high return on investment, we ask ourselves two questions. First: Is the high return on assets due to a high net margin or high asset turnover? Second: What is the ROA (margin + turnover) of a company in its sector?

#3.2 Return on equity formula

When we look at the ROA formula in relation to DuPont, we look at the company as a whole. But let’s be a little selfish and look at the company only from the shareholder’s point of view. To do this, let’s express the ROE formula in terms of the Dupont equation: word-image-4597 What does this formula mean? In order for a company to provide better returns to its shareholders (owners), it must first ensure its productivity. How do you do that? By using its assets effectively to generate income (high return on investment). Second, the company can also use leverage to improve its return on equity. But using financial levers is not that simple. The company should treat leverage with extreme caution. Let me explain: word-image-4598 Not all companies can use debt to improve return on equity. Why? There is no doubt that debt gives the company leverage. But debt also has a price (interest charges). As a result, a company that incurs debt will experience a decrease in net income. So why choose debt? They will only do so if their asset turnover rate is exceptional (more than one). For these companies, taking on debt means a significant increase in turnover and therefore an increase in the return on equity.

#3.3 Return on Investment (ROI)

Another litmus test for identifying moat companies is calculating their ROIC. It is similar to the ROA, but with some changes. These changes make the formula more suitable for demonstrating the realistic profitability of a company. First, let’s note the difference between ROA and ROIC. word-image-4599

  • NOPAT : The net result is the numerator of ROA. However, the ROIC uses NOPAT. NOPAT is the best measure of a company’s profitability. Why? Since the component Other income is also taken into account in deriving profit from net income. However, the NOPAT only takes into account the operating profit.

NOPAT = operating income X (1- effective tax rate)

  • Invested capital : The sum of total equity and total liabilities is the total assets. But not all employees work for the company. The money that is still in the bank in the form of cash is useless. Therefore, it cannot be reported as invested capital. In addition, trade debts must be deducted from total assets. Why? In fact, this part of the capital is invested in the company by the suppliers.

Invested capital = total assets – cash and cash equivalents – trade payables Companies with little other income, cash and debt will have the same ROA and RoIC. So how do you know if a company’s ROI performance is good or not? Generally, RoIC companies have a RoIC of more than 15% over a long period of time (e.g., 7-10 years).

Supplement

It is not easy to identify these types of companies. So how do the experts do it? They study the market by observing the behavior of customers and competitors towards the company and its products. It would not be wrong to say that finding mobile home companies is indeed a quality job. But in this article, we looked at some numbers that may give a strong indication of a gap. The two strongest measures are FCF and ROI performance, as outlined above. Thank you for reading and good luck with your investments. Next >> Quality of managementA moat is a term that describes the key differences between successful companies and their competition. A company with a large moat is considered to have a strong competitive advantage over its competitors, allowing it to attract and retain customers, and to keep revenues and profits high. A moat might be natural, such as a larger market share or superior infrastructure, or it might be built through a series of decisions and actions.. Read more about economic moat examples and let us know what you think.

Frequently Asked Questions

How do I find a company’s moat?

The word “moat” is a bit of a buzzword these days, but the definition is actually pretty simple. A moat, in business, is a sustainable competitive advantage that prevents a competitor from gaining market share. In other words, it’s a source of income that keeps investors interested in the company, and will keep them from exiting the stock because of a down stock price. Moats are inherently difficult to analyze because they require a thorough understanding of the business, and most companies are not well-known enough to have a moat. However, there are a few key metrics that can help you identify moat companies.

What are moat companies?

There is a lot of talk about moat companies. Here is a short list of what a company can have. Different companies have different ingredients and are more or less important. Wall street analysts and so called moat-investors define these differently. 1. Market Size 2. Market Penetration 3. Market Share 4. Market Differentiation 5. Brand Strength 6. Brand Recognition 7. Brand Longevity 8. Price 9. Barriers to Entry 10. Exit Strategy 11. Momentum 12. Leading Indicators 13. Leaders in the Industry 14. Dominant Competitors 15. Customer Relationships 16. Cost Structure 17. New Product Introduction 18. Moats are a company’s competitive advantage. A company has a moat if it has strong competitive advantages over its competitors. A company may have multiple moat components, like customer loyalty, patent, brand, network effects, strengths, etc. – but in general, a company with a strong competitive advantage has a moat. In this post we will look at a few examples of moat companies and determine if they will be sustainable or not.

What is moat Warren Buffett?

Warren Buffett is widely regarded as the greatest investor of the modern era, and his approach to investing is widely emulated by other successful investors. However, this approach has its shortcomings. It can lead to some nasty mistakes when a company is not actually a good investment, which is why many portfolio managers have a bias towards investing in strong moats. Warren Buffett, the CEO of Berkshire Hathaway is a popular investor and not a very well known billionaire. He has really good investment ideas and he doesn’t waste any time in making money for himself. He is a very wise investor and he has made his name in the market.

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About the author

Trader Pit

A yogi who like Finance and Technology. I have been in Indian Stock market for over 12 years now as financial analyst, portfolio manager, trader. Now, I focus on Yoga, Financial Education & Long term investing. 

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