Moat Report Card: How It Works

Many investors have trouble assessing the strength of a company's economic moat. To help them out, I started the Fool's Moat Report Card in July 2010.

Warren Buffett's "moat" metaphor is well known and widely accepted: If your company's business is a castle, its ability to keep competitors at bay is that castle's moat. If the moat is wide, deep and guarded by Monty Python's Black Knight, your company can prosper for a long time, and it deserves to trade at a premium to other companies. If the moat looks more like a melted ice cube, well, prepare for the plundering and pillaging of your company's profits.

Unfortunately, it's tough to translate that moat metaphor into hard numbers, or quantify just how strong a company's moat really is. Your best bet to measure a moat lies in analyzing returns on invested capital (ROIC). If your company's generating more returns on its capital than it's spending to acquire that capital, it can put that excess cash to all sorts of good uses, including dividends, buybacks, and reinvestments.

Many investors believe that growth is the defining characteristic of a potential investment. But growth that doesn't earn high returns actually shrinks the company's value! Worse yet, ROIC figures aren't always reliable at first glance; some result more from accounting wizardry than solid business performance.

Three questions to ask
To find investments that will truly make us rich in the long haul, we need to ask the following three questions about returns:

1. Over time, has the company earned a sufficiently high ROIC?
2. Is the ROIC of high quality?
3. Is the company maintaining and growing the returns it earns on invested capital?

To answer these questions, I've created a proprietary moat report card that analyzes a company's financial statements. It's not intended to be a Magic 8-Ball, but hopefully it'll get you pointed in the right direction.

ROIC history
Strong returns on capital are one sign of a potential moat. A company's ability to earn excess returns over the long haul helps it pile of treasure behind its forbidding fortress gates. We like to see returns greater than 10%. If they outpace the returns competitors earn, even better!

To measure a company's strength in this department, I look at five years' worth of three-year rolling returns on invested capital. This time frame smoothes out volatility and gives me a better view of the big picture. If the average ROIC in these five rolling periods is greater than a 10% hurdle cost of capital, we've got a potential moat on our hands.

I also compare this data to the same numbers from the subject company's closest competitor. If the archrival's earning dramatically higher returns than the company we're looking at, I dock the grade. Conversely, if the subject company is beating the pants off its nemesis, its grade gets a boost.

Because only profitable returns add value to the firm, we assign a 30% weighting if a company's consistently earning more than that basic cost-of-capital hurdle, and 20% if it's surpassing its competition in the process.

ROIC quality
Just like return on equity, there are only so many ways a firm can juice its ROIC. Profit margins, asset turnover, and leverage are the three main levers here.

Leverage can have a major impact on ROIC, but it represents a financing decision, rather than solid business execution. Fatter margins and greater asset turnover are much better signs of real improvements in a company's business. That's why we love to see companies improving their returns on capital by increasing profit margins and becoming more efficient, all of which plays out in a company's operating return on assets (ROA).

To assess the quality of a company's ROIC, I look at the its ROIC would have been if the company had used the amount of leverage common in its industry. The math behind this standardized ROIC is simple:

Standardized ROIC = Company operating ROA * Industry leverage

I then compare the standardized ROIC over time with the industry average ROIC, assigning a good grade for outperformance and a low grade for underperformance.

ROIC growth
The bigger the castle, the harder competitors will try to storm the gates. Companies that can consistently improve their ROIC compared to their competitors are likely widening their moats. We check to see that a firm is at least maintaining -- and hopefully growing -- ROIC relative to its prospective invaders. This category accounts for the remaining 30% of the grade.

Ideally, we'd like to invest in companies that improve the returns they earn over time, even as their competition struggles. By comparing the ROIC growth rate in absolute terms, and relative to the growth experienced by its nearest competitor, we can better understand whether the company's competitive position is strengthening or weakening. (You probably won't be surprised to hear that we favor the former.)

The final grade
To get a comprehensive grade for a company's moat, I've weighted the categories based on the factors I consider most important. Generating returns on invested capital above 10%, for example, is more important to me than generating more ROIC growth than the competition, because only returns above the cost of capital matter. If our company is generating 3% returns on capital, but growing its ROIC by 25% per year, it's still achieving unprofitable growth.

Here's a sample report card:

The final grade is determined by the following score ranges:

A word about ROIC
I calculate ROIC by dividing after-tax operating profits by operating capital. To come up with after-tax profits, I subtract the effective tax rate from the number 1, then multiply the result by operating income. To get operating capital, I add the book values of debt and equity, then subtract a company's cash.

Why exclude cash? First, those after-tax profits don't include interest income -- the benefit of holding cash. Leaving cash out of operating capital keeps things consistent. Second, keeping cash on hand is management's choice. If executives wished, they could pay all that cash out to shareholders, lower their capital base, and manufacture an increase in their ROIC. For fairness's sake, you'll find the flipside of the cash argument here.

I hope the Moat Report Card is a useful research tool. If you have any questions about it, please send me an email.