How to Measure a Company’s Competitive Advantage

One key ingredient to ensuring that a company can earn excess returns over time: a durable competitive advantage.

If a company has a successful product or service, it won’t be long before rivals try to produce a similar or better product. So, how do companies protect against rivals encroaching on their territory?

Legendary investor Warren Buffett referred to a company’s ability to do so as its “economic moat.”

We borrowed this term for the Morningstar Economic Moat Rating, which systematizes the concept and measures the strength of each company’s defense. We evaluate every company’s competitive edge, and how long we expect this edge to last.

Companies with economic moats are more likely to create value for themselves and their shareholders over the long haul than companies without economic moats. That’s why we think most investors should use these companies as a starting point for identifying their core holdings.

What Is an Economic Moat?

At Morningstar, we assign companies a wide moat, narrow moat, or no moat.

If a company has a wide moat, it has a strong defense against rival companies that we think can last 20 years or more. A company with a narrow moat should remain competitive for at least 10 years. And no-moat companies don’t have any enduring advantages that will enable them to outlast their competitors over time.

Just because a company boasts a well-known brand, or has been in business a long time, does not necessarily mean it has an economic moat. We’ve all heard of United Airlines UAL and Ford F, but we don’t believe that those companies are positioned to fend off competitors in their industries.

In our methodology, a company’s economic moat is derived from one (or more) of five factors: cost advantage, intangible assets, network effect, switching costs, and efficient scale.

We refer to these factors as moat sources.

All companies that we assign an economic moat hold at least one of these advantages. Below, we describe what contributes to these moat sources, and a few examples of each.

Moat Source Number 1: Cost Advantage

Cost advantage is an intuitive proposition: the lower the costs, the better for a company’s competitive advantage.

One way a company can achieve lower costs is by being larger and having greater size and scale. For example, firms are able to spend more on advertising, buy in larger quantities for potential discounts, and distribute more units through a cost-effective distribution network.

A good example of this moat source is wide-moat McDonald’s MCD. With nearly $130 billion in global systemwide sales, the largest restaurant brand in the world can procure food and paper more cost effectively than its smaller peers—an edge that we do not expect to abate over the next few decades.

Moat Source Number 2: Intangible Assets

The moat source of intangible assets consists of unique features like brand equity, patents, proprietary technology, and favorable regulation that allow a company to generate excess returns.

Take Starbucks SBUX. It’s certainly not the cheapest option for coffee, but it holds its own in the market because of its brand equity—that is, the value associated with the brand. People recognize the Starbucks brand, know what they’re getting for it, and are willing to pay for it.

This brand equity provides pricing power, meaning that Starbucks can set its prices higher than peers in the relatively commoditized coffee category without losing traffic.

Regulation, proprietary technology, and patents follow a similar line of thinking, but instead of being able to price better than competitors, it’s about gaining an edge over your competitors through legal involvement.

For example, healthcare companies benefit from patent protection, which legally bars competition. This gives firms the ability to be the sole producer of a given product and ensure pricing power for as much as 20 years.

Moat Source Number 3: The Network Effect

A network effect means that the value of a product or service improves for new and existing users with each additional user. The network effect is arguably one of the most potent competitive advantages, and it can also quickly catapult firms ahead in new industries.

Let’s look at Google GOOGL. The more searches Google has, the more it can refine its search performance and iterate based on user input and feedback. In other words: The more people use Google, the better the product—and therefore, the more inclined you are to keep using it.

If a company can constantly improve its product based on its users and new users, this provides it with a competitive advantage over firms that are not able to do the same. Moreover, Google has been able to monetize this network by consistently improving targeted advertising, offering the best return on investment for advertisers only achieved through an established network. This network advantage has given Google the ability to keep competitors at bay.

Moat Source Number 4: Switching Costs

If it’s tough for customers to switch products—either because of the associated price tag or the associated risk or hassle—they’re less likely to go through with the switch. This is a moat source known as “switching costs.”

When a company can use strong switching costs to keep customers “locked in” to their products, it’s easier for them to increase prices year after year without risking losing those customers to competitors.

Consider a firm that is enrolled with an HR software provider like Workday WDAY.

Every firm employee is trained on the software, and the firm’s other processes are integrated into this system. Switching HR software providers would be time-consuming and expensive: The firm would need to retrain all employees and reintegrate with a new product, making the cost of leaving Workday prohibitive. This gives Workday an edge over its competitors and the ability to boast high customer retention.

The banking industry also benefits from the switching costs moat source.

You might be familiar with the hassle of moving all your account information from one bank to another. Even if another bank offers the same services for $1 less per month or a slightly higher interest rate on deposits, is all the extra effort needed to switch worth it?

The same goes for your credit cards: You might be able to get a better deal on credit cards elsewhere—but it might not be worth it if you already have rewards and points on your existing cards, have your utility bills automatically charged, or enjoy the familiarity that having the same account for a long time offers.

Moat Source Number 5: Efficient Scale

Companies that serve markets that are limited in size—and therefore only provide enough business for a few competitors—benefit from “efficient scale.”

This may apply to industries like railroads or utilities. These industries don’t see as many new entrants to the space, because there’s limited opportunity for further expansion and the market is efficiently served by a small number of companies. And because the entry of a new firm would take market share from existing firms rather than capture market growth, too many competitors would lower the industry’s returns below the cost of capital.

By nature, this type of moat is less common, but it can be a strong advantage.

Let’s look at a railroad company like Union Pacific UNP. There’s little incentive for new firms to enter the railroad market because of the sizable upfront infrastructure costs. Plus, competing with Union Pacific would mean they run the risk of creating excess capacity with limited demand. This gives Union Pacific the ability to maintain its size and position in the railroad industry.

The Bottom Line on Economic Moats

While every company with an economic moat benefits from at least one of these moat sources, all else equal, it’s even better if they benefit from more than one. Why? Because moat sources can erode or increase over time.

Economic moats are a core tool for determining which companies you should focus most of your investing attention on.

But finding companies with economic moats is just the first step: You want to make sure to buy these companies when they’re trading below what they’re worth.

This article includes updated content that originally appeared in Morningstar’s stock investing course, which was distributed by the Professional Education Institute.