Practical stock researchModule 2, lesson 6 of 23
Judging competitive advantages in practice
How to test a claimed competitive advantage with evidence such as returns on capital, margins, market share and pricing power across a full cycle.
In this lesson
- Turn a claimed competitive advantage into tests that evidence can pass or fail.
- Use margins, returns on capital and market share over a cycle as evidence.
- Look for evidence of pricing power and customer loyalty.
- Explain why management's description of its moat is not evidence that it exists.
Builds on
- Comparing companies in the same sectorMoat tests compare a company with its true peers.
- Return on capital employed (ROCE)Sustained high returns on capital are the main evidence of an advantage.
On this page
In simple terms
Many companies describe themselves as having a strong brand, a loyal customer base or unique technology. The competitive advantage lesson explained the main kinds of moat. This lesson is about testing whether one really exists, using evidence rather than descriptions.
The core idea: if a business has a real advantage, competitors cannot copy its profits away, so its returns stay high for a long time.
Test 1: returns on capital over a cycle
The strongest evidence is a return on capital employed that stays well above the company's cost of capital year after year, including in bad years, as the ROCE lesson explains.
Worked example: Two made-up companies over eight years
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
|---|---|---|---|---|---|---|---|---|
| Company A ROCE | 28% | 30% | 27% | 29% | 31% | 26% | 28% | 30% |
| Company B ROCE | 35% | 12% | 30% | 8% | 25% | 5% | 22% | 15% |
Both averaged high returns at times. But A held them through good and bad years, which suggests something protects its profits. B's swings look like a cyclical business enjoying good years, as the cyclical businesses lesson describes.
Test 2: margins and market share
- Gross and operating margins that stay stable, or rise, as the company grows suggest pricing power and cost advantages.
- Market share held or gained over many years, without buying it through price cuts or heavy spending, suggests customers prefer the company.
Industry bodies, regulators and competitors' reports are useful sources for market share.
Test 3: pricing power
Pricing power is the ability to raise prices without losing many customers. Evidence includes:
- Price increases announced in results without a fall in volumes, as the products and customers lesson explains.
- Margins recovering quickly after input cost spikes, as the commodities lesson discusses.
- Customers who stay despite cheaper alternatives.
Test 4: compare with peers
An advantage is relative. If every company in an industry earns high returns, the industry may be in a good period, protected by regulation, or not yet attracting competition. Compare with true peers over the same years, as the comparing companies lesson explains.
Claims are not evidence
Annual reports and investor presentations often describe moats in glowing terms. Treat every such statement as a claim to test:
| Claim | Evidence to look for |
|---|---|
| "Strong brand" | Price premium over rivals, stable volumes after price rises |
| "Loyal customers" | Low customer churn, long relationships, repeat orders disclosed |
| "Cost leadership" | Margins above peers at similar prices; lower cost per unit |
| "Network effects" | Value to users rising with the number of users; share gains |
| "High switching costs" | Customers rarely leaving; long contracts |
If the evidence is missing, the moat may be weaker than claimed, or not exist.
Threats to a moat
Even real advantages erode. Watch for:
- New technology that changes how customers buy.
- Regulation that removes protection or caps prices.
- Well-funded competitors willing to accept losses for years.
- Management spending the advantage's profits on poor acquisitions, as the capital allocation lesson discusses.
Why it matters
Valuations of companies with real advantages often assume high returns for many years. If the moat is weaker than believed, those assumptions fail. Testing the moat with evidence is the best protection against paying for an advantage that does not exist.
Limitations
History may not predict the future, especially when industries change. Some advantages are new and not yet visible in the numbers. High returns can also come from accounting choices or temporary conditions. Evidence reduces uncertainty but does not remove it.
Common mistakes
- Taking management's word for the moat.
- Judging on one or two good years.
- Ignoring peers in the same period.
- Assuming a moat lasts forever.
Try it yourself
- For a company you are researching, write down the competitive advantage it claims.
- Collect its return on capital, operating margin and market share for at least eight years, and the same for two peers.
- Find any evidence of price increases and their effect on volumes.
- Write whether the evidence supports the claim, and what could erode it.
Key takeaways
- A competitive advantage, or moat, should show up in the numbers. Returns on capital stay above the cost of capital, and margins and market share hold up through a full cycle.
- Pricing power, the ability to raise prices without losing many customers, is strong evidence of an advantage.
- Compare with true peers. An advantage is relative; a whole industry earning high returns may simply be enjoying a good period.
- Management's description of its moat is a claim to test, not evidence.
- Moats erode. Look for threats such as new technology, regulation, or competitors with deeper pockets.
Check your understanding
Finished reading?
Your progress is saved only in this browser.
Terms used in this lesson
- Economic moat
- A lasting competitive advantage that lets a company earn returns above its competitors' for many years.
- Return on capital employed
- Operating profit (EBIT) divided by the capital provided by shareholders and lenders together, a measure of business quality little affected by debt.
- Pricing power
- A company's ability to raise prices without losing many customers, one of the clearest signs of a competitive advantage.
Spotted a mistake or something unclear? Report it by email. Here is how corrections work.
This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.