Quite simply, an economic moat is a long-term competitive advantage that allows a company to earn oversized profits over time. The term was coined by one of our favorite investors of all time, Warren Buffet, who realized that companies that reward investors over the long term have a durable competitive advantage. Assessing that advantage involves understanding what kind of defense, or competitive barrier, the company has been able to build for itself in its industry. 

Moats are important from an investment perspective because any time a company develops a useful product or service, it isnt long before other firms try to capitalize on that opportunity by producing a similar--if not better--product. Basic economic theory says that in a perfectly competitive market, rivals will eventually eat up any excess profits earned by a successful business. In other words, competition makes it difficult for most firms to generate strong growth and profits over an extended period of time since any advantage is always at risk of imitation.

The strength and sustainability of a companys economic moat will determine whether the firm will be able to prevent a competitor from taking business away or eroding its earnings. In our view, companies with wide economic moats are best positioned to keep competitors at bay over the long term, but we also use the terms narrow and none to describe a companys moat. We dont often talk about the depth of a moat, yet its a good way of thinking about how much money a company can make with its advantage.

To determine whether or not a company has an economic moat, follow these four steps:

1. Evaluate the firms historical profitability. Has the firm been able to generate a solid return on its assets and on shareholder equity? This is probably the most important component to identifying whether or not a company has a moat. While much about assessing a moat is qualitative, the bedrock of analyzing a company still relies on solid financial metrics.

2. Assuming that the firm has solid returns on its capital and is consistently profitable, try to identify the source of those profits. Is the source an advantage that only this company has, or is it one that other companies can easily imitate? The harder it is for a rival to imitate an advantage, the more likely the company has a barrier in its industry and a source of economic profit.

3. Estimate how long the company will be able to keep competitors at bay.
We refer to this time period as the companys competitive advantage period, and it can be as short as several months or as long as several decades. The longer the competitive advantage period, the wider the economic moat.

4. Think about the industrys competitive structure. Does it have many profitable firms or is it hypercompetitive with only a few companies scrounging for the last dollar? Highly competitive industries will likely offer less attractive profit growth over the long haul.

Next: Types of Economic Moats >>

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