Economic Moats

[via Yuvaraj] Morningstar writes:

We begin with the premise that all highly profitable firms attract competitors, and only firms that are able to keep competition at bay will earn above-normal profits for a long time. An economic moat–or competitive advantage–allows a company to fend off competitors and earn sustainable excess economic profits. We look at return on invested capital (ROIC) relative to the company’s cost of capital to determine profitability, because ROIC shows us the cash return on the capital invested in the business. We think that ROIC is the best measure of a firm’s true economic profitability.

Of course, we have to examine ROIC relative to a firm’s cost of capital because money isn’t free–those who have capital charge companies for the right to use it, and they charge some companies more than others. A firm that operates pipelines or sells beer has a low cost of capital because it has a stable business, so investors don’t ask for much in the way of returns. A small semiconductor or biotech firm would have a very high cost of capital because it’s entirely possible that investors might not get their money back, so they ask for a high return to compensate for the higher risk. For example, an ROIC of 14% would be spectacular for a pipeline company relative to its 8% cost of capital, but would barely clear the bar for a small tech or biotech firm.

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Rajesh Jain

An Entrepreneur based in Mumbai, India.