If your business doesn’t have a moat, it is unpredictable at best. Can money be made in no-moat businesses? Absolutely-but it is a gamble at best. Ben Graham, Warren Buffett’s mentor and friend, stated:
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
Though a small- or no-moat business may offer a “satisfactory” return, it does not promise safety of principal. So, we invest in wide, deep, shark-infested moat businesses. But, how do we put a value on that moat and factor it into our price?
We don’t.
The Price Of Moat
A moat is a durable, competitive advantage that protects your owner earnings for years to come. It provides stability, consistency, and confidence in your assessment. The moat is part of the art of investing-the intangible force shield that allows your business to sustain high owner earnings and returns on capital and allows you to estimate, with a degree of certainty and confidence, the value of your business.
The moat does not come with a price that should be added to your business’ value. Moat determines the value by allowing you to project owner earnings. Another way to say it: You shouldn’t pay a premium just because there is a moat.
How does moat factor in? Invest only in businesses with moats-big, fat moats. Skip everything else.
The Bigger The Moat…
Every company has a value, though some are more easily calculated. The moat affects the value only to the extent that it determines how long you can project high, sustained owner earnings. But, moat also affects the purchase price by determining your margin of safety.
The bigger the moat, the smaller your margin of safety needs to be because it protects you from slowed or erratic growth. Think about it-what were the obstacles to Coca-Cola’s growth in 1988? Certainly not fierce competition. Coke’s moat was huge which allowed investors to buy with a lower margin of safety because the future was so certain.
The Moat Durability
When valuing a business, you project the owner earnings and buy them at a discount today. But, it is not rational to think only in terms of 5- or 10-year timeframes. For example, how long will Google be the search engine? Three years? Seven? How long will Google have rapid, sustained owner earnings before a competitor comes in to steal market share?
If Google’s moat will last five years, your value calculation should show five years of high growth, followed by progressively lower growth for the following fifteen.
Oh, and if you’re not entirely sure-move on to the next company. Just because a company is growing doesn’t mean you have to buy it or justify buying it. There’s always another boat coming.
My Moat Problem
I’m right there with you, Sammy. I don’t know precisely how to value AAPL so I have to gamble or pass. I’ll pass. The same is true for Adobe-I know it will grow, I know it has a huge moat, but I can’t figure out a value yet. I want to own Adobe, but I refuse to overpay or throw money in blindly without knowing the value.
Of course, if I can figure it out, I’ll post it here.
Filed under: How to Value a Business
Hi Joe,
a truely inspiring blog, the more I read the more I have gain in confidence that I might just have a clue what I am doing finally when I am looking for good companies. I would like to hear more about your thoughts with a company such as Adobe. I am heavily involved in using there products and realise their incredible moat in the design world which with the future of Flash and Internet services, can only grow even with Microsoft shooting at them from the starboard side with Silverlight. However, having worked through their finances as you have taught in your blog, I realise they seem grossly over priced, by my calculation…..I would love to know firstly if I have maybe completely miscalculated, or if I need to consider many more things about the company before contemplating a company like Adobe as a good investment. I cannot imagine the Co. losing that much value in its share price to match my calculations anytime in the next 10+ years. What are your views? I am not looking for a buy confirmation, more the detailed understanding of why they can be so over priced compared to what they are worth, would you expect the share price to fall to fall in line with intrinsic value?
Many thanks for all the education
Stuart
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Joe,
I found the following passage from a book:
“Return on Invested Capital (ROIC) must be greater than the Weighted Average Cost of Capital (WACC), otherwise growth has no value.”
RIOC is pretty easy to compute (CROIC, in your case). But how do you compute for WACC? Is there a quick and dirty analysis for this?
Thanks!
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Be careful with WACC. Check out this exchange between Charlie Munger and Professor William Bratton on this very topic.
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“Munger has his own idea of how the cost of capital should be measured. Buffett has explained that at Berkshire, the cost of capital is measured by the company’s ability to create more than $1 of value for every $1 of earnings retained. “If we’re keeping $1 bills that would be worth more in your hands than in ours, then we’ve failed to exceed our cost of capital,” Buffett said.”
WOW!
Thanks again for another insight.
That “retained earnings test” really shed light into it and made it much more simpler. I googled WACC as BPal suggested and got the concept but still its complexity somewhat eluded me.
(Thanks, still for that, BPal. I just can’t get my head around on too much complexity (“,). I’m still learning and reading every investment book I can get my hands on.)
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Correlating the value of a moat into market prices, when Mr. Market gets pessimistic, he prices wide-moat companies absurdly low. That translates into a buying opportunity. When he comes into his senses and gets rational, the price will adjust as the business grows larger than the industry. And when the crowd notices it and starts rushing in with Mr. Market’s greediness, we sell and wait for another opportunity.
This is what happened in the Philippines on Feb. I jumped in with my two feet without having to do much number crunching (I would be able to find more bargains if I did). I’m lucky, to have found this website early in my investing career!
ps. the prescription might read: repeat until rich.
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Thanks, Joe. I’m sure I speak for the rest of the readers when i say that your blog entries are truly golden. You have nailed the concept of “edu-tainment” dead on. Thank you for all the effort you put into your blog.
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