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By Pat Dorsey, CFA | 08-27-2010 01:24 PM

What's the Real Value of an Economic Moat?

Morningstar's Pat Dorsey on why it's worth paying up a little bit for a wide moat business versus a no moat business.

Pat Dorsey: Hi, I am Pat Dorsey, director of equity research at Morningstar.

As those of you who are familiar with Morningstar's equity research probably know, we are big fans of what we think of as competitive advantage or economic moats in the way we look at stocks here at Morningstar.

And one of the things people often ask me is, so why do you care, Pat. What is so important about economic moats? Why should they be an important part of your analytical process? And I think the answer is pretty simple.

Well, first of all, moats add intrinsic value. A company that's able to compound cash at a very high rate of return for many years into the future is simply worth more today in present value terms than a company that's not.

You can imagine three triangles, if you think about returns on capital starting very high and then fading down low over a long period of time, all that area is value creation. All that time is opportunity where the company can basically reinvest capital at a high rate of return, protect itself from the competition, and thus increase its value and thus make it more valuable to you today as a shareholder.

Whereas the no moat business where you might see returns on capital starting high, but then coming down very, very quickly as competition comes in and pulverizes it--well, all else equal, that's just worth less today in present value terms. So, it's reasonable to pay up a little bit for a wide moat business versus a no moat business.

Now, does that mean a wide moat business is worth two times a no-moat business? Hardly, but it is worth a bit more and this is why you often hear, this company deserves to trade at a premium, a quality company is trading at a premium, that's sort of jargon on Wall Street. And what that is, is basically getting at this intuition that a business that is able to compound cash at a high rate of return for many years is worth more today in present value terms.

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