Analysing a Company's Economic Moat

In ancient times, cities were defended by having a moat around its walls. This was one effective strategy to keep attackers at bay and give the city an added advantage when it comes to defending itself in war.

A company's economic moat does the exact same thing. It keeps competitors at bay. Analysing a comapny's economic moat is thus of important relevance to stock investors.

A few methods have been proposed to analysing a company's economic moat. Here are the steps:

1. Evaluate the firm's historical profitability. (Focus on free cash flow, net margins, returnon equity and return on assets)

2. Source of economic moat. Is the economic moat built through product differentiation, low costs, locking in of customers or locking out competitors through high barriers of entry?

3. How much money the firm can make and for how long? How profitable is the firm might be easy to analyse but for how long it can retain its competitive advantage is really difficult to analyse. Various competitive advantages depend on the source of economic moat and this in turn will determine how long the firm can remain profitable. Basically, economic moats that are based on technological innovation tend to be highly profitable in the short term but also is likely to be short-lived.