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Why Moats Matter: The Morningstar Approach to Stock Investing by Heather Brilliant, Elizabeth Collins

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Chapter 2What Makes a Moat?

Now that you have the big picture of what we mean by economic moat and why we think it’s so important for successful stock investing, let’s get into the details of how we define and identify moats for individual companies.

To determine a company’s economic moat rating, we start by asking two questions:

  1. Are the company’s returns on invested capital, or ROIC, likely to exceed its weighted average cost of capital, or WACC, in the future?1
  2. Does the company appear to have at least one of the five sources of sustainable competitive advantage (intangible assets, cost advantage, switching costs, network effect, or efficient scale)?

In this regard, our moat methodology considers both quantitative and qualitative factors—the ROIC-WACC spread, also referred to as economic profits, and the moat sources, respectively. A firm generates economic profits when its earnings exceed not only accounting costs but also investors’ opportunity costs. A firm can generate positive net income, or positive accounting profits, without posting economic profits if it doesn’t reward equity investors for putting their money in the business.

The process of answering these fundamental questions about future economic profits and sustainable competitive advantages includes carefully researching the company and its industry. At Morningstar, our process includes analyzing the company’s financial statements, talking to its managers, visiting the firm’s operations when relevant, and reading ...

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