Economic Moats & Durable Competitive Advantage
Apple Inc. (AAPL)
Fiscal Year
Net Income
Sales
Assets
Shareholders' Equity
Net Margin
Asset Turnover
Return on Assets (ROA)
Financial Leverage
Return on Equity (ROE)
Cash Flow from Operations
Capital Expenditures
Free Cash Flow (FCF)
FCF / Sales
Net Income
Dividends
Shareholders' Equity
Long-Term Debt
Total Capital
Return on Invested Capital (ROIC)
Operating Income
Net Fixed Assets
Working Capital
Return on Capital (ROC)
Operating Income
Enterprise Value
Earnings Yield
Return on Assets (TTM)
Return on Assets - 5 Yr. Avg.
Return on Investment (TTM)
Return on Investment - 5 Yr. Avg.
Return on Equity (TTM)
Return on Equity - 5 Yr. Avg.
Gross Margin (TTM)
Gross Margin - 5 Yr. Avg.
2004
2005
2006
276,000
1,335,000
1,989,000
8,279,000
13,931,000
19,315,000
8,050,000
11,551,000
17,205,000
5,076,000
7,466,000
9,984,000
3.33%
9.58%
10.30%
1.03
1.21
1.12
3.43%
11.56%
11.56%
1.59
1.55
1.72
5.44%
17.88%
19.92%
934,000
2,535,000
2,220,000
(176,000)
(260,000)
(657,000)
758,000
2,275,000
1,563,000
9.16%
16.33%
8.09%
276,000
1,335,000
1,989,000
5,076,000
7,466,000
9,984,000
5,076,000
7,466,000
9,984,000
5.44%
17.88%
19.92%
326,000
1,650,000
2,453,000
707,000
817,000
1,281,000
4,375,000
6,816,000
8,038,000
6.41%
21.62%
26.32%
326,000
1,650,000
2,453,000
5,462,696
23,555,277
55,511,905
5.97%
7.00%
4.42%
Company
Industry
Sector
19.34
6.4
12.83
23.65
7.83
12.57
24.62
30.93
11.74
14.05
32.62 -33.38
Operating Margin (TTM)
Operating Margin - 5 Yr. Avg.
2008
4,834,000
32,479,000
39,572,000
21,030,000
14.88%
0.82
12.22%
1.88
22.99%
9,596,000
(1,091,000)
8,505,000
26.19%
4,834,000
21,030,000
21,030,000
22.99%
6,275,000
2,455,000
20,598,000
27.22%
6,275,000
165,141,717
3.80%
2009
5,704,000
36,537,000
53,851,000
27,832,000
15.61%
0.68
10.59%
1.93
20.49%
10,159,000
(1,144,000)
9,015,000
24.67%
5,704,000
27,832,000
27,832,000
20.49%
7,658,000
2,954,000
16,983,000
38.41%
7,658,000
72,012,296
10.63%
2010
14,013,000
65,225,000
75,183,000
47,791,000
21.48%
0.87
18.64%
1.57
29.32%
18,595,000
(2,005,000)
16,590,000
25.44%
14,013,000
47,791,000
47,791,000
29.32%
18,385,000
4,768,000
20,956,000
71.47%
18,385,000
184,298,606
9.98%
16.58
17
30.64
14.57
36.56
16.59
Company
Industry
Sector
37.62
19.15
40.4
19.78
EBITD Margin (TTM)
EBITD - 5 Yr. Avg
2007
3,496,000
24,006,000
25,347,000
14,532,000
14.56%
0.95
13.79%
1.74
24.06%
5,470,000
(735,000)
4,735,000
19.72%
3,496,000
14,532,000
14,532,000
24.06%
4,409,000
1,832,000
12,657,000
30.43%
4,409,000
65,921,267
6.69%
Date: 10/30/13
Last Fiscal Year Ended: 09/30/13
2011
2012
2013
25,922,000
41,733,000
37,037,000
108,249,000
156,508,000
170,910,000
116,371,000
176,064,000
207,000,000
76,615,000
118,210,000
123,549,000
23.95%
26.67%
21.67%
0.93
0.89
0.83
22.28%
23.70%
17.89%
1.52
1.49
1.68
33.83%
35.30%
29.98%
37,529,000
50,856,000
53,666,000
(4,260,000)
(8,295,000)
(8,165,000)
33,269,000
42,561,000
45,501,000
30.73%
27.19%
26.62%
25,922,000
41,733,000
37,037,000
(2,488,000) (10,564,000)
76,615,000
118,210,000
123,549,000
16,960,000
76,615,000
118,210,000
140,509,000
33.83%
33.20%
18.84%
33,790,000
55,241,000
48,999,000
7,777,000
15,452,000
16,597,000
17,018,000
19,111,000
29,628,000
136.28%
159.83%
106.00%
33,790,000
55,241,000
48,999,000
293,036,374
369,633,240
481,235,182
11.53%
14.94%
10.18%
18.4
18.02
49.16
50.85
-10.52
23.28
28.67
30.92
7.24
8.05
10.93
17.35
Pre-Tax Margin (TTM)
Pre-Tax Margin - 5 Yr. Avg.
29.35
31.4
7.7
8.29
11.77
17.83
Net Profit Margin (TTM)
Net Profit Margin - 5 Yr. Avg.
21.67
23.34
5.46
6.09
5.95
12.43
Effective Tax Rate (TTM)
Effective Tax Rate - 5 Yr. Avg.
26.15
25.65
27.27
25.2
26.84
30.95
Receivable Turnover (TTM)
Inventory Turnover (TTM)
Asset Turnover (TTM)
14.22
83.45
0.89
8.19
20.89
1.49
5.92
140.75
0.96
 Economic Moats can protect companies from competition, helping them earn more money for a long time, and therefore making them more valuable to an investor.
 Return on Capital (ROC) is the best way to judge a company’s profitability.
 Mistaken Moats: 1) Great Products (i.e. Krispy Kreme, Netscape), 2) Strong Market Share (i.e. Chrysler’s minivan, IBM’s PCs, General Motors), 3) Great Execution (i.e. Kodak), and 4) Great
Management (i.e. JetBlue). They do not create long-term competitive advantages. They are nice to have, but they’re not enough.
 The four sources of structural competitive advantage are 1) Intangible Assets (brands, patents, licenses, etc.), 2) Customer Switching Costs (products or services that are hard to give up
like banks), 3) Network Economics (i.e. credit cards, Microsoft Windows and Office), and 4) Cost Advantages (stems from process, location, scale or access to a unique asset). If you found a
company with one of these characteristics with solid ROC, you’ve probably found a company with an economic moat.
 It’s easier to create a competitive advantage in some industries than it is in others. See page 118 for Moats by Sector.
 Measuring Return on Capital:
1. Return on Assets (ROA) measures how much income a company generates per dollar of assets.
2. Return on Equity (ROE) measures the efficiency with which a company uses shareholders’ equity and is a great overall measure on returns on capital. (Note: A flaw in using ROE is a
company can take on a lot of debt and boost ROE without becoming more profitable)
3. Return on Invested Capital (ROIC) combines the best in both worlds by measuring the return on all capital invested in the firm (both debt and equity).
 Bet on the horse, not the jockey. Management matters, but far less than moats.
 The Moat Process:
Has the firm historically generated solid ROC?
i) No
(1) Is the firm’s future likely to be different from its past?
(a) No = No Economic Moat
(b) Yes
(i) High Switching Costs, Network Economics, Low-Cost Production, and/or Intangible Assets
1. No = No Economic Moat
2. Yes = Economic Moat
a. How strong is the company’s competitive advantage? Is it likely to last a long time or a relatively short time?
i.
Short = Narrow Moat
ii. Long = Wide Moat
ii) Yes
(1) Does the firm have on or more of the following competitive advantages: High Switching Costs, Network Economics, Low-Cost Production, and/or Intangible Assets?
(a) No = No Economic Moat
(b) Yes
(i) How strong is the company’s competitive advantage? Is it likely to last a long time or a relatively short time?
1. Short = Narrow Moat
2. Long = Wide Moat

Valuation Tools to Consider:
o Price-to-Sales = most useful for companies temporarily unprofitable or posting lower profit margins.
o Price-to-Book = most useful for financial services firms, because the book value of these companies more closely reflects tangible value of the business.
o Price-Earnings = beware of the Earnings used, because forecasts aren’t always reliable. Estimate your own Earnings
o Price-to-Cash Flow = can help you spot that earns lots of cash relative to earnings.
o Yield-based Valuations = useful because you can compare the results directly with alternatives.
 Warren thinks that the best kind of business to own is one with high profit margins and high turnover.
 Warren believes the second-best kind of business to own is one with either high profit margins or a high turnover to compensate for lower profit margins.
 Warren is not interested in owning a business with both low profit margins and low turnover.
 Warren has a selective contrarian investment philosophy where he will pass on price-competitive businesses regardless of how great the buying opportunities look.
 Two-types of Competitive Advantage: 1) Unique Product or 2) Unique Service.
 Not just competitive advantage but Durable Competitive Advantage (a business must be able to keep its competitive advantage well into the future without having to expend great sums of capital
to maintain it).
o Low-cost Durability like Hersey’s chocolate company.
 Four-types of businesses with Durable Competitive Advantages:
1) Businesses that fulfill a repetitive consumer need with products that wear out fast or are used up quickly, that have brand-name appeal, and that merchants have to carry or use to
stay in business.
2) Advertising businesses, which provide a service that manufacturers must continuously use to persuade the public to buy their products.
3) Businesses that provide repetitive consumer services that people and businesses are consistently in need of (i.e. tax preparers, cleaning services, security services and pest control).
4) Low-cost producers and sellers of common products that most people have to buy at some time in their life (i.e. jewelry, furniture, carpet, and insurance).
 Quality companies are protected by economic moats, the all-important competitive advantage that makes it hard for competitors to gain market share. This economic moat is a concept worth
remembering and applying in your analysis; even a good company without an economic moat won’t last long.

Four basic types of economic moats:
a. Brand (Coca-Cola is sells better and is more profitable than a generic brand of soda).
b. Switching (customer loyalty or the inability and unwillingness to go elsewhere).
c. Cost (dominating a commodity type industry through lower prices for the same or better value).
d. Protection (ownership of a product or service that no one else is able to offer).
 ROE and Net Profit Margin are two of the first ratios to look at to determine possible economic moats. Compare them to industry averages and are trending higher they are worth looking at. If
not, it’s a waste of time so look elsewhere.
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To look for Economic Moats, look for firms that consistently earn high profits. Focus on Free Cash Flow, Net Margins, ROE and ROA.
In general, there are five ways that a firm can build a durable competitive advantage:
o Creating real product differentatiation through superior technology or features.
o Creating perceived product differentiation through trusted brand or reputation.
o Driving costs down and offering a similar product or service at a lower price.
o Locking in customers by creating a high switching costs.
o Locking out competitors by creating high barriers to entry or high barriers to success.
Like Economic Moats, some industries are easier to make money in than others.
Measuring Growth = Four Sources:
o Selling more goods or services.
o Raising prices.
o Selling new goods or services.
o Buying another company.
Free Cash Flow = Cash Flow from Operations – Capital Spending
o FCF / Sales => Anything above 5% is doing a solid job at generating excess cash.