After a 200% rise over the past 12 months, Netflix (Nasdaq: NFLX) has certainly rewarded investors. But does the company have a wide enough moat to keep competitors at bay for the long haul?

The stuff moats are made of
Warren Buffett coined the term "economic moat" to describe the strength of a company's competitive advantages. Many factors confer short-term competitive advantages, but in his excellent The Little Book That Builds Wealth, Morningstar's Pat Dorsey convincingly argues that only four factors create an enduring economic moat. Let's use Dorsey's criteria to see what Netflix's moat is made of and just how sustainable it is.

1. Intellectual property rights
Moat-building intellectual property includes intangible assets such as patents, licenses, and brands. Any company can have a brand, but truly moat-widening brands must increase a consumer's willingness to pay for a product.

Moat source: no
Sure, consumers like the Netflix brand, but they aren't willing to pay more for a movie just because it comes in a cute red envelope. When rival Blockbuster lowered the price of its DVD subscription plans back in 2007, Netflix quickly followed suit. That's not how a company with a wide-moat brand would respond.

2. Customer switching costs
Products that are tightly integrated with a customer's business or lifestyle make it difficult for that customer to switch to a competitor's product.

Moat source: slight
Coinstar's (Nasdaq: CSTR) Redbox and the joint venture Hulu can tempt Netflix's subscribers with cheaper movies, but these low-cost competitors can't hope to duplicate Netflix's powerful movie recommendation engine or personalized movie queues. These unique features will make subscribers think twice before jumping ship.

3. The network effect
The value of some services increases in direct proportion to the number of people using them. For example, Facebook offers a much richer experience with 500 million users than it did with a handful of undergraduate dorm mates.

Moat source: no
While it's true that each new Netflix member could incrementally improve the recommendation engine and movie review database, I don't think that's sufficient to support a sustainable economic moat. The average member's Netflix experience is not meaningfully improved by each incoming member.

4. Cost advantages
Finally, lower costs can create lasting competitive advantages. The benefits of operational efficiencies and smart processes inevitably erode over time. A truly sustainable cost advantage, like economies of scale or a superior geographic location, simply can't be copied.

Moat Source: yes (for now)
Netflix's greatest competitive advantage -- its uber-efficient DVD delivery system -- is the biggest factor keeping competitors at bay today. Unfortunately for the company, this advantage is steadily eroding as digital delivery becomes more common.

Netflix's distribution centers and information systems enable the company to deliver physical DVDs within one business day to 97% of its member base. Potential competitors would have to invest multiple years and hundreds of millions of dollars to replicate this capability. However, the playing field for distributing movies digitally is much more level. Netflix has the first-mover advantage in digital delivery and has signed a number of shrewd partnerships to embed its technology in consumer devices such as the Xbox 360, PlayStation 3, and Wii, but competitors' barriers to entry will be much lower in the future than they are today.

Numbers don't lie
To determine whether a company enjoys a sustainable competitive advantage, examine its return on invested capital over time. Returns consistently exceeding a company's cost of capital suggest that it possesses a nice moat. Here's how Netflix's ROIC stacks up next to Blockbuster:













Source: Capital IQ, a division of Standard & Poor's.

Survey says: narrow moat!
As you can see, Netflix currently enjoys phenomenal returns on invested capital, thanks in large part to its prowess in delivering physical DVDs. But the competitive landscape is shifting by the minute -- and not in Netflix's favor. With $1-a-day rentals and plenty of new releases, Coinstar is chewing up the low end of the market, while companies such as Apple (Nasdaq: AAPL) and (Nasdaq: AMZN) are trying to capture the per-rental (rather than subscription) market. And we can't overlook the threat posed by on-demand offerings from cable companies Time Warner Cable (NYSE: TWC) and Comcast (Nasdaq: CMCSA), or the movie studios themselves, who surely would like to get a slice of the action.

Ready to buy?
Not so fast, my Foolish friends! Even if you believe that Netflix can widen its narrow moat and fend off the coming competition, that doesn't automatically make it a smart buy. While competitive advantage is critical, it's also essential for investors to have a strong understanding of a company's management, finances, and valuation -- and to always buy at a significant margin of safety.

That's the strategy our team at Motley Fool Inside Value employs. You can read all of the team's research reports and see their best buys for new money now, with a 30-day free trial.