Our report Measuring the Moat Assessing the Magnitude and Sustainability of

Our report measuring the moat assessing the magnitude

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Our report, “Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation,” develops a framework for this vital analysis.20For now, we will focus on how a quick analysis of ROIC indicates whether a company has a competitive advantage and, if so, what lies at the foundation of that advantage. Bruce Greenwald, a professor at Columbia Business School, argues that there are two sources of competitive advantage: consumer advantage and production advantage. The key to each advantage is the creation of barriers to entry that fend off competition. Barriers to entry are particularly strong when a company enjoys economies of scale, which mean that the cost per unit for the incumbent is lower than that for a challenger.21A consumer advantage is the result of the habitual use of a product, high costs of switching to a new product, or high costs of searching for a superior product. A production advantage allows a company to deliver its goods or services more cheaply than its competitors either as the result of privileged access to inputs or to proprietary technology that is difficult or costly to imitate. A competitive strategy analysis focuses on identifying these sources of advantage and assessing their durability. ROIC can provide a quick and useful way to guide this analysis. The first step is to recognize that ROIC can be decomposed into two parts (this is a modified version of what is known as a DuPont Analysis): Return on invested capital (ROIC) = NOPAT x ____Sales____ Sales Invested Capital The ratio of NOPAT/Sales, or NOPAT margin, is a measure of profit per unit. Sales/Invested Capital, or invested capital turnover, is a measure of capital efficiency. When you multiply the terms, sales cancel out and you are left with NOPAT/Invested Capital, or ROIC. It is easy to imagine two companies arriving at the same ROIC via different paths. A low-cost retailer, for example, may get to a 20 percent ROIC via a 4 percent NOPAT/Sales ratio and a 5 times Sales/Invested Capital ratio, the classic low-margin, high-invested capital turnover business. A luxury goods seller, on the other hand, may reach the same ROIC with a 20 percent NOPAT/Sales ratio and one times invested capital turnover. Here’s the quick analysis: If a company gets to a high ROIC through a high NOPAT margin, you should focus your analysis on a consumer advantage. If the company’s high return comes from a high turnover ratio, emphasize analysis of a production advantage. For companies that are high in both, consider how the advantages are reinforced by economies of scale. Exhibit 5 summarizes the point.
June 4, 2014 Calculating Return on Invested Capital15Exhibit 5: ROIC and Competitive Advantage Source: Credit Suisse. The decomposition of ROIC not only provides a solid sense of where to allocate your energy in assessing advantage, analysis of the components provides a sense of the rate of change. You can do a similar breakdown of ROE for financial institutions, which also allows for an analysis of the contribution of leverage to ROE.

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