Narrow vs. Wide Economic Moat: What is the Difference?
There are two different types of economic moats:
- Narrow Economic Moat → A narrow economic moat refers to a marginal competitive advantage over the rest of the market. While technically still representing an advantage, these sorts of moats tend to be short-lived.
- Wide Economic Moat → However, a wide economic moat, on the other hand, is a competitive advantage far more sustainable and difficult to compete with in terms of market share.
What are the Different Types of Moats in Business?
The common sources of economic moats include the following:
| Factor |
Example |
| Network Effects |
- The value of a product or services increases as the number of users on the platform rises (e.g. Facebook/Meta, Google)
|
| Switching Costs |
- The marginal benefits of moving to a different provider are outweighed by the associated costs (e.g. Apple)
|
| Economies of Scale |
- The cost of production on a per-unit basis declines as the company expands in scale (e.g. Amazon, Walmart)
|
| Intangible Assets |
- The proprietary technology, patents, trademarks, and branding belonging to a company (e.g. Boeing, Nike)
|
How to Identify an Economic Moat in Stocks?
1. Unit Economics
The economic moat will be evident in a company’s unit economics in the form of consistent operational performance and profit margins on the high-end relative to the industry average.
Companies with economic moats more often than not have higher profit margins, which are a byproduct of favorable unit economics and a well-managed cost structure.
Thus, if a company has an economic moat, sustainable long-term value creation can be attained.
If a company consistently has a better margin profile than the rest of the market, then this is typically one of the first signs of an economic moat.
The most common measures of profitability are as follows.
| Profitability KPI |
Formula |
| Gross Margin (%) |
- Gross Margin (%) = Gross Profit ÷ Revenue
|
| Operating Margin (%) |
- Operating Margin (%) = EBIT ÷ Revenue
|
| EBITDA Margin (%) |
- EBITDA Margin (%) = EBITDA ÷ Revenue
|
| Net Profit Margin (%) |
- Net Profit Margin (%) = Net Income ÷ Revenue
|
| Basic Earnings Per Share (EPS) |
- Basic Earnings Per Share (EPS) = (Net Income – Preferred Dividends) ÷ Weighted Average Common Shares Outstanding
|
| Diluted Earnings Per Share (EPS) |
- Diluted Earnings Per Share (EPS = (Net Income – Preferred Dividends) ÷ Weighted Average of Diluted Common Shares Outstanding
|
2. Value Proposition and Differentiation
Just because a company has high margins does not signify a moat, because there must also be an identifiable, unique advantage.
In other words, there must be a unique value proposition and/or a strong reason behind the durability of the future profits (e.g. cost advantages, patents, proprietary technology, network effects, branding).
Additionally, the factors should be very difficult to replicate by other competitors in the market and come with barriers to entry such as high switching costs or capital requirements (i.e. capital expenditures, or “Capex”).
3. Return on Invested Capital (ROIC)
The final KPI that we’ll discuss is the free cash flow (FCFs) of a company, which is directly tied to the company’s capacity to spend on growth and re-invest into its operations.
The more efficient a company can convert its operating cash flows into free cash flow (FCF) – i.e. FCF conversion and FCF yield – the more cash flows are available to use to obtain a higher return on invested capital (ROIC).
Return on Invested Capital (ROIC) = NOPAT ÷ Average Invested Capital
The creation of a long-term economic moat requires a company to find its own competitive edge, but also to recognize that its continued profit generation depends on constant adjustments to adapt to changing environments as new trends emerge (e.g. Microsoft).
As a general rule, the more defensible a company’s economic moat, the more challenging it becomes for existing competitors and new entrants to breach this barrier and steal market share.
What is an Real-Life Example of an Economic Moat?
Economic moats can be viewed as protective barriers against threats to the competitive positioning of companies, so stronger moats mean higher “hurdles” for the rest of the market.
For instance, Apple (AAPL) is a clear example of a company with an economic moat from various sources, but the one we’ll focus on here is its switching costs.
The more difficult it is to switch to a rival offering – either due to monetary reasons or convenience – the stronger the moat is around the incumbent, or, in this case, Apple.
For Apple, not only is it expensive for customers to switch to a different product offering, but it is difficult to escape the so-called “Apple Ecosystem”.
Apple Product Line (Source: Apple Store)
If a consumer has a MacBook, you can likely bet that the person also owns an iPhone and AirPods.
The more Apple products that you own, the more benefits you can derive from each product due to how compatible and well-integrated they are (i.e. “the whole is greater than the sum of the parts”).
Hence, the Apple product users tend to be some of the most loyal customers, which directly coincides with more long-term recurring revenue.
