9 Metrics To Help You Assess If a Company Has a Moat
It's not always easy to identify a moat, but here're some ways you can do so.
Bear market fatigue hits when you keep buying and the market keeps dipping. At times, it may feel like the market will never return to its former highs.
One way to overcome this fatigue is to go back to basics. Looking at the moat of the companies in your portfolio is a good starting point. The problem is that it might not always be easy to identify a company’s moat, even for the most advanced investors.
Here are 9 ways to tell if a company has a moat:
1) Gross Margin
Where: Income Statement
Calculation: Gross Profit / Revenue
Moat: Consistently above 40%.
No moat: Below 40% and volatile
A consistently high gross margin signals that the company is not competing on price alone. A high gross margin also provides ample gross profit to pay expenses and leaves money for shareholders.
2) Sales, General, and Administrative Expenses (SG&A)
Where: Income Statement
Calculation: SG&A / Gross Profit
Moat: Consistently under 30%
No Moat: Over 80% & volatile
Wide moat companies don’t need to spend a lot on overhead to operate. No moat businesses do. Buffett looks for companies that consistently spend under 30% of their gross profit on SG&A.
3) Depreciation Expense
Where: Income Statement & Cash Flow Statement
Calculation: Depreciation / Gross Profit
Moat: Consistently under 10%
No Moat: Highly volatile
If depreciation is consistently less than 10% of gross profit, it means that the company doesn’t need a lot of capital expenditure assets to maintain its competitive advantage.
4) Interest Expense
Where: Income Statement
Calculation: Interest Expense / Operating Income
Moat: Consistently under 15%
No Moat: Over 50% & volatile
Great businesses don’t need to rely on debt. While this number varies greatly from industry to industry, it’s a great sign if a company consistently spends less than 15% of its operating income on interest.
5) Income Tax Expense
Where: Income Statement
Calculation: Income Tax Paid / Pre-tax Income (Earnings Before Tax)
Moat: Consistently pays the full amount (~21% in U.S.)
No Moat: Negative and inconsistent
Wide moat businesses make so much money that they are consistently forced to pay their full share of taxes. Companies that consistently have negative or an inconsistent income tax bill are unlikely to have a durable moat.
6) Profit Margin (Net Margin)
Where: Income Statement
Calculation: Net Income / Revenue
Moat: Consistently above 20%
No Moat: Below 10%, negative, and volatile
Companies that consistently convert 20% of their revenue into net income are likely to have a moat. If this number is under 10%, negative, or highly volatile, it's an indication that competition is fierce.
7) Capital Expenditures
Where: Income Statement & Cash Flow Statement
Calculation: Capital Expenditures / Net Income
Moat: Consistently under 25%
No Moat: Consistently above 25%
Capital expenditures eat into company profits. Companies that don’t have to spend big on capex have more money to reward shareholders. Averaging the result over a 10-year period or more is optimal as capital expenditures can vary from year to year.
8) Total Liabilities to Adjusted Shareholder Equity
Where: Balance Sheet
Calculation: Total Liabilities / Shareholder Equity
Moat: Below 0.80
No Moat: Over 2.00
Wide moat businesses finance themselves with profits, not debt. However, share buybacks might skew the numbers. Adjust for this by adding back any treasury stock to the shareholder equity number.
9) Return on Shareholders’ Equity (ROE)
Where: Balance Sheet & Income Statement
Calculation: Net Income / Shareholder Equity
Moat: Consistently above 15%
No Moat: Below 10%, negative, or volatile
Return on equity shows how effectively management is reinvesting its profits. A number consistently over 15% indicates that the business has a moat. Anything under 10%, negative, or volatile indicates that the business is struggling to fend off competition.
Additional Pointers to Note
1) Where is the company in the business cycle?
This only works for companies in the mature stage of a company’s business cycle. This is when the company is “optimised” for profits.
2) Consistency of Numbers
A company has to show that it is able to generate these numbers over multiple years and periods. The longer the better.
Investing comes with many nuances. Not all companies can pass all 9 of these criteria. Even the companies that Warren Buffett hold do not pass all of these. But these serve as good reference points to begin identifying a moat.
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