Investment Basics - Course 305 - Quantifying Competitive Advantages
This is the twentieth Course in a series of 38 called "Investment Basics" - created by Professor Steven Bauer, a retired university professor and still active asset manager and consultant / mentor.
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 Courses 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.
Prof's. Guidance: Yes, more on "moats." I like the term and yet I do not use it enough. What separates the company you choose to have in your portfolio from the "also rans" - it the trick. A very good question is: is this company poised to move / appreciate?
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.
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 (HOG) 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 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.
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 after-tax 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)
Prof's. Guidance: We aren't just doing random basic 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 (not so good lately). 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.
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.
Prof's. Guidance: Remember 2005 was a very good time for both companies and the stock market! Other years may not be so kind. That's why you are taking this course of study. Being wise enough to avoid the negative times, in one way or another, is also a trick you had better learn and learn well!
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. I will explain cost of capital in detail in Course 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.
Thanks for attending class this week - and - don't put off doing some extra homework (using Google - for information and answers to your questions) and perhaps sharing with the Prof. your questions and concerns.
Investment Basics (a 38 Week - Comprehensive Course)
By: Professor Steven Bauer
Text: Google has the answers to most all of your questions, after exploring Google if you still have thoughts or questions my Email is open 24/7.
Each week you will receive your Course Materials. There will be two kinds of highlights: a) Prof's Guidance, and b) Italic within the text material. You should consider printing the Course Materials and making notes of those areas of questions and perhaps the highlights and go to Google to see what is available to supplement those highlights. I'm here to help.
Course 101 - Stock
Versus Other Investments
Course 102 - The Magic of Compounding
Course 103 - Investing for the Long Run
Course 104 - What Matters & What Doesn't
Course 105 - The Purpose of a Company
Course 106 - Gathering Information
Course 107 - Introduction to Financial Statements
Course 108 - Learn the Lingo & Some Basic Ratios
Course 201 - Stocks & Taxes
Course 202 - Using Financial Services Wisely
Course 203 - Understanding the News
Course 204 - Start Thinking Like an Analyst
Course 205 - Economic Moats
Course 206 - More on Competitive Positioning
Course 207 - Weighting Management Quality
Course 401 - Understanding Value
Course 402 - Using Ratios and Multiples
Course 403 - Introduction to Discounted Cash Flow
Course 404 - Putting OCF into Action
Course 405 - The Fat-Pitch Strategy
Course 406 - Using Morningstar as a Reference
Course 407 - Psychology and Investing
Course 408 - The Case for Dividends
Course 409 - The Dividend Drill
Course 501 - Constructing a Portfolio
Course 502 - Introduction to Options
Course 503 - Unconventional Equities
Course 504 - Wise Analysts: Benjamin Graham
Course 505 - Wise Analysts: Philip Fisher
Course 506 - Wise Analysts: Warren Buffett
Course 507 - Wise Analysts: Peter Lynch
Course 508 - Wise Analysts: Others
Course 509 - 20 Stock & Investing Tips
This Completes the List of Courses.
Wishing you a wonderful learning experience and the continued desire to grow your knowledge. Education is an essential part of living wisely and the experiences of life, I hope you make it fun.
Learning how to consistently profit in the Stock Market, in good times and in not so good times requires time and unfortunately mistakes which are called losses. Why not be profitable while you are learning? Let me know if I can help.