Deciding whether or not a company has an economic moat is certainly more art than science. It largely involves looking at qualitative factors that influence competitive positioning. But those qualitative factors that we spoke of in our level two lessons can, in fact, be measured by analysing select numbers found in the financial statements. It is most certainly prudent to make sure a company you are interested in does indeed have a moat before buying. In this lesson, we'll tell you what to look for, while this article explains how we ascertain whether a company will be able to stand the test of time.
Free cash flow
Strong free cash flow is a hallmark of firms with moats, provided that
the cash flow comes from ongoing operations and not one-time events.
Remember, free cash flow represents the funds left over after a firm has
already reinvested in its business to keep it running. It is usually
defined as operating cash flow minus capital expenditures (both measures
are found on the cash flow statement). If a firm's free cash flow as a
percentage of sales is greater than 5%, you've probably found a cash
machine and a good basis to dig deeper to see if the company has an
economic moat.
Profit margins
Remember that there are three main types of profit margins we can
measure: gross, operating, and net. These three look at gross profit,
operating profit, and net income as a percentage of sales. In a
nutshell, margins tell you how much of each type of profit a company is
generating per pound of sales.
It should make sense that companies with economic moats generally have larger profit margins than their competitors. Tesco may sell an apple at the same price as a local grocery store but if Tesco’s costs are lower, its profit margins on the sale of the apple will be higher. Likewise, it may cost the same for Harley-Davidson and one of its competitors to build a motorcycle, but Harley should be able to sell its bike at a higher price because of its brand. Harley will have the higher profit margin.
A net margin consistently in excess of 15% is a good benchmark that often indicates a company has sustainable competitive advantages. Do keep in mind, however, that margins by themselves are of limited use; you also have to consider the context of turnover and return, which we will discuss shortly.
Turnover
Turnover measures how efficiently a company is using its assets to
generate sales. Several types of turnover can be used to measure
efficiency, but perhaps the most relevant for our discussion here is
total asset turnover, or sales divided by total assets. All else equal,
a company with higher turnover than its competitors is more efficient
and may have some sort of advantage.
As with profit margins, turnover is of limited use when considered in a vacuum. Rather, it is usually best to compare the turnovers of companies in the same industry. Likewise, turnover should usually be used in the context of profit margin and return.
Return on equity and assets
Remember that return on equity (ROE) measures profits per pound of the
capital shareholders have invested in the company. Meanwhile, return on
assets (ROA) measures the same thing, but over the entire asset base,
not just equity.
Both are good measures of the overall profitability of a company. Companies with moats will usually have higher returns than their competitors.
There are two decent return benchmarks that can be used across most industries: If a company has generated ROAs in excess of 10% and/or its ROEs have been in excess of 15% for some time, the company may indeed possess a moat.
DuPont equation
We've mentioned that margin and turnover mean little when used by
themselves and should be compared with the margins and turnover ratios
of other, very similar companies. There is one equation, the so-called
DuPont equation, that helps tie all the concepts together. The DuPont
equation simply breaks down the components of ROA and ROE. You may
recall the following formula for ROA (for simplicity, we will ignore
aftertax interest expenses):
Return on Assets = Net Profits / (Average Assets)
But we can also express ROA this way:
Return on Assets = (Asset Turnover) x (Net Profit Margin)
If we break this equation down further by defining turnover and margin, we can see why this works--sales in the definitions of turnover and margin cancel each other out:
ROA = ((Sales) / (Average Assets)) x ((Net Profits) / (Sales))
= (Net Profits) / (Average Assets)
We aren't just doing random algebra for fun here. Rather, this highlights the two different ways a company can create high returns for itself. Companies can either use their assets more efficiently to generate sales, or they can have higher profit margins, or both.
Margins versus turnover
Let's look at the two ways--margin and turnover--that a company can
create high returns for itself. Thanks to the several types of moats it
possesses, Microsoft
is incredibly profitable, with gross profit margins of 84% and net
profit margins of 26% in early 2005. This means for every dollar of
sales it generates, its cost of goods sold are only $0.16. Meanwhile,
even after all overhead expenses and taxes, it still generates $0.26 in
bottom-line profit per dollar of sales.
But Microsoft does not turn over its assets very effectively, having a total asset turnover of only 0.5 in early 2005. Part of this is because a large chunk of its assets are represented by a giant cash hoard that is not generating anything but mere interest income. As such, Microsoft's ROA was "only" 13% in early 2005 (26% net profit margin times 0.5).
Wide-moat American retailer Wal-Mart is at the opposite end of the spectrum. Its net profit margin was only 3.6% in early 2005, or a little more than one-eighth that of Microsoft. However, it turned its assets over 2.6 times over the preceding year. As a result, its ROA was a little over 9% at that time (3.6% times 2.6).
DuPont and ROE
To use the DuPont equation to calculate a company's ROE, we have to add
a step to the process to account for the amount of leverage (debt) a
company employs. We can break down ROE using the DuPont equation as
follows:
ROE = ROA x (Asset / Equity Ratio)
ROE = (Asset Turnover) x (Net Profit Margin) x (Asset / Equity Ratio)
ROE = (Sales / Average Assets) x (Net Profits / Sales) x (Average Assets / Average Equity)
= (Net Profits) / (Average Equity)
Notice that in the ROE breakdown, both sales and average assets cancel each other out.
One can draw the same insights about operating efficiency (profit margins) and asset use efficiency (turnover) as with ROA, but this adds the element of leverage to the equation. Clearly, companies can use leverage (debt) in order to boost their ROEs.
Return on invested capital
The best way to determine whether or not a company has a moat is to
measure its return on invested capital (ROIC). This is similar to ROA
but is a bit more involved. The upshot is it gives the clearest picture
of exactly how efficiently a company is using its capital, and whether
or not its competitive positioning allows it to generate solid returns
from that capital.
ROIC = (Net Operating Profit After Taxes--NOPAT) / (Invested Capital--IC)
Notice the numerator is a nonstandard measure, meaning you will not find it on any standard financial statement. We have to calculate it ourselves. The name "net operating profit, after taxes" is fairly descriptive, but you can also think about NOPAT as simply net income with interest expense (net of taxes) added back. We do this to figure out what the profit would be without taking a company's capital structure into consideration.
NOPAT = (Operating Profit) x (1 - Tax Rate)
For the denominator, invested capital is yet another nonstandard, calculated measure not found on any financial statement. Invested capital tries to measure exactly how much capital is required to operate a business. It can be defined as such:
IC = (Total Assets) - (Excess Cash) - (Non-Interest-Bearing Current Liabilities)
This equation introduces two new terms that need some explanation. Excess cash can be defined as the cash a company has that is not required to operate the business. For example, Microsoft clearly does not need the full $35 billion in cash and investments it has in its war chest to keep the business running, and we can subtract a portion of that cash because that capital is not really invested in the business.
The most salient example of a non-interest-bearing current liability is accounts payable. The reason we subtract accounts payable from the invested capital base is because, if you think about it, accounts payable represent capital invested in the business by a company's suppliers, not the company itself. Other forms of liabilities that we should probably subtract out are deferred revenues and deferred taxes. (We say "probably" because, like excess cash, determining what liabilities do and do not represent invested capital requires a lot of judgment.)
Once you have gone through the exercise of calculating an ROIC for a company, how do you know if it has a wide moat? Typically, if a company has an ROIC in excess of 15% for a number of years, it most likely has a moat. That said, whether a company is creating value depends on whether its ROIC exceeds its cost of capital. We will explain cost of capital in detail in coming lessons.
The bottom line
Figuring out whether or not a company has an economic moat remains
largely a qualitative exercise, but the numbers should confirm your
observations. Companies with wide economic moats should have strong free
cash flow and handsome returns on invested capital.
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