A company with a very profitable business is like a castle that is constantly under attack by competitors. Without a strong defence, competitors will soon imitate the company’s products, charge lower prices, steal market share, and erode profit margins to the point where the business is merely average, at best.
Economic moats — a term Morningstar borrowed from Warren Buffett — are what keep competitors at bay. An economic moat is a sustainable competitive advantage that allows a company to earn excess returns on capital for a long period of time. Morningstar analysts assign every company in our coverage universe an economic moat rating: either wide, narrow, or none.
Starting With the Basics: A Lemonade Stand
The most important quantitative evidence of an economic moat is if a company has a high return on invested capital, or ROIC. Investors — both shareholders and creditors — require a certain level of return in exchange for providing a company the funds it needs to run its business. This is called the weighted average cost of capital, or WACC. A company generates excess returns if its ROIC consistently exceeds its WACC.
For example, imagine little James wants to open a lemonade stand. He needs £100 upfront to buy a table, a jug, lemons, sugar, ice, and cups. This is his invested capital. James borrows £50 from his mother and promises to pay her 5% interest (£2.50). Dad has a higher risk tolerance, so he buys £50 worth of common stock in Jame’s lemonade stand. Dad expects a 10% return (this is called the cost of equity).
The lemonade stand’s invested capital is funded with 50% equity and 50% debt. The weighted average cost of capital is exactly what it sounds like, a weighted average of the cost of equity and debt capital. It is calculated as:
(0.5 x 5%) + (0.5 x 10%) = 7.5%
If James’ lemonade stand were just any ordinary business, we would expect its return on invested capital to match its WACC: 7.5%. But James is an exceptional salesman, and when the day is done he has earned a £10 profit, after paying himself a reasonable wage and replenishing his stock of lemons, sugar, ice, and cups. The lemonade stand’s ROIC is 10% (£10/£100), and James has achieved excess returns on capital.
Beware of Competitors
At this point, James is feeling pretty satisfied, and his dad is ecstatic. After paying Mum’s £2.50 in interest, James has £7.50 left over to either reinvest in the business or distribute to Dad as a dividend. Dad’s return on equity is 15% (£7.50 divided by his £50 investment), well ahead of the 10% cost of equity he was expecting. It’s good to be a stockholder.
Unfortunately, James’ lemonade stand lacks an economic moat. His sister Sarah hears about his successful business venture, and decides she wants in. Mum and Dad can hardly show favouritism to one child over the other, so they agree to fund Sarah with the same £50 in debt and £50 in equity. Sarah sets up shop the next morning right next to James.
When James and Sarah count the day’s take, they find that each has earned a profit of £6. ROIC has fallen to 6% (£6/£100), and both James and Sarah have failed to earn their cost of capital. Mum is still doing OK, collecting £5 of interest on her £100 total investment. But now there is only £7 left for Dad: a 7% return on his £100 investment. Dad had been expecting to earn at least 10%—the sleepless night he spent worrying about his equity investment wasn’t worth the measly 7% return. James wishes he could push Sarah into a real moat.
Wider, Deeper, and More Alligators
This example may seem simplistic, but it illustrates the most important aspect of our methodology. We look for companies that can earn excess returns on capital for many years, because the business is protected by a strong competitive advantage: a wide economic moat.
Morningstar has identified five potential sources of an economic moat, which are described below. Every company with an economic moat rating of wide or narrow exhibits at least one of these sources of advantage, and in some cases more than one.
Network Effect
The network effect occurs when the value of a company’s service increases for both new and existing users as more people use the service. For example, the 
London Stock Exchange (LSE) possesses a narrow economic moat. The company benefits from scale, which should allow it to profit from rising trading activity without a similar escalation in costs. Unique products, also contribute moatiness.
Intangible Assets
Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company’s products, or allow the company to charge a significant price premium. For example, Burberry (BRBY) has a wide economic moat due to the brand equity in its centuries-old Burberry name and image, and expectations of returns on capital that should remain well ahead of its cost of capital over the long run.
Cost Advantage
Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins. For example, British American Tobacco (BATS) has popular brands, global reach, and addictive products which give the company a wide economic moat. Restrictions on advertising in developed markets and strong loyalty to cigarette brands keep market shares stable and make it foreboding for new entrants to gain traction.
Switching Costs
When it would be too expensive or troublesome to stop using a company’s products, the company often has pricing power. For example Smith & Nephew (SN.) smaller, mid-tier position in orthopaedics, as well as its presence in the less attractive wound-care market, we think the firm has only dug a narrow economic moat.
Efficient Scale
When a niche market is effectively served by one or a small handful of companies, efficient scale may be present. For example, Rexam (REX) has a narrow moat derived primarily from its efficient manufacturing scale and the oligopolistic nature of its major markets. A potential competitor has little incentive to enter the North American, European, and South American markets because it would struggle to sustainably maintain sufficient market share.
Premium members will find Morningstar analysts' moat assessments on the Morningstar Research Report of each company under coverage.
