What it means
An economic moat is whatever stops rivals from copying a company's success and competing away its profits. A wide moat means that protection is expected to last for a long time, and a narrow moat means it is real but shorter lived.
Companies with no moat are exposed to competition that gradually pushes their returns down to ordinary levels. The usual sources of a moat are brand strength, switching costs, network effects, cost advantages and legal protections.
Switching costs occur when it is painful for customers to change supplier, for instance moving a company's accounting records to a new system. Network effects occur when a service becomes more valuable as more people use it, as with a payments network or a marketplace.
Investors care because a moat supports pricing power, stable margins and high returns on the money invested in the business. A company that can raise prices without losing customers, or that can reinvest at high returns year after year, is worth far more than one that cannot.
The valuation benefit shows up in a longer period of above-average growth and a higher justified multiple. For non-finance professionals, the idea is useful beyond stock picking.
Managers can ask whether their own business has a moat, how wide it is and whether it is growing or shrinking. Suppliers, partners and lenders can ask the same question about the companies they deal with, since a company with a wide moat is more likely to be a reliable counterparty.
Moats are judgements, not measurements, and they can be wrong. Technology change, regulation and new business models have drained moats that once looked unbreachable, so a "wide" label is a forecast and not a guarantee.
Good analysts check the evidence in the numbers, especially returns on capital held over many years.
In practice
Real-world examples.
Example
A subscription accounting software provider has customers whose financial records, staff training and integrations are all tied to its system. Even when a cheaper rival appears, few customers switch because the cost and disruption are high, which is the switching-cost moat in action.
Example
A global payments network is accepted by millions of shops, and shoppers carry its cards because shops accept them. A new entrant must win both sides at once, so the network effect protects the incumbent's fees.
Example
A low-cost airline with a scale advantage in fuel purchasing and aircraft use can set fares that smaller rivals cannot match without losing money. An analyst rates its cost advantage as a moat, though a narrow one because fuel costs and fares remain volatile.
Formula
Calculation
Economic profit spread = Return on invested capital (ROIC) - Weighted average cost of capital (WACC)
Annual economic profit = Spread x Invested capital
Suppose a software company earns an after-tax operating profit of $60,000,000 on invested capital of $300,000,000. ROIC is 60,000,000 / 300,000,000 = 20%. If its cost of capital is 8%, the spread is 20% - 8% = 12%. Annual economic profit is 12% x 300,000,000 = $36,000,000, and a wide moat means the market expects that spread to last, rather than shrink toward zero.Case study
Seen in the real world.
Anchor Ledger Systems is a fictional company that sells payroll software to mid-sized businesses. In this illustrative example, an investment analyst gave it a wide moat rating because customers rarely left, with revenue retention above 95% for ten years. She backed the rating with its return on invested capital, which stayed near 18% against a cost of capital of 8%.
When a venture-backed rival launched a cheaper product, Anchor's customers largely stayed because of integration with their banks and tax filings. The analyst kept the rating but flagged the risk that artificial intelligence tools might reduce those switching costs over time. The illustrative lesson is that a moat should be tested every year, not declared once.
Watch out
Common mistakes.
- Assuming that a famous brand or a large size automatically means a wide moat, when many large companies have lost their advantage.
- Treating a moat rating as a buy signal, when a company with a wide moat can still be a poor investment if the price paid is too high.
- Ignoring the numbers, since a real moat should appear as high returns on capital for many years.
Questions
People also ask.
Who invented the idea of an economic moat?
The image is widely credited to Warren Buffett, who used it to describe businesses protected from competition, and Morningstar later built a rating system on it.
What is the difference between a wide and a narrow moat?
A wide moat is expected to last for about twenty years or more, while a narrow moat is expected to last for around ten years, according to Morningstar's framework.
Can a moat disappear?
Yes, changes in technology, law or customer taste can shrink a moat, which is why analysts reassess it regularly.
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