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305-Quantifying Competitive Advantages
  Course 305:
  Quantifying Competitive Advantages
  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 Lessons 205 and 206 can, in fact, be measured by analyzing 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.
  
  
  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 dollar of sales.
  
  It should make sense that companies with economic moats generally have larger
  profit margins than their competitors. Wal-Mart WMT may sell an apple at the
  same price as a local grocery store. But if Wal-Mart'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 HDI 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 dollar 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.
  
  
  Margin vs. 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 MSFT 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 retailer Wal-Mart WMT 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).
  
  Of course, companies that can create both high profit margins and turnover can
  generate exceptionally strong returns. In early 2005, Adobe ADBE had 28% net
  profit margins and asset turnover of 0.9, for an ROA of 25%. Another example:
  Moody's MCO had 30% net profit margins and turnover just over 1.2 in early
  2005, for an ROA above 36%. We qualitatively observed in Lesson 205 that Adobe
  and Moody's had moats, and the numbers back those observations up.
  
  
  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 a 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 Lesson 403.
  
  
  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.