Warren Buffett's 9 Rules of Thumb to Identify a Company's Moat!

Capitalism can be ruthless, and when investing, it's crucial to identify companies with a competitive advantage, often referred to as a "moat." Warren Buffett, a renowned investor, follows several financial "rules of thumb" to assess if a company has a moat. Here are nine of these rules:

1) Gross Profit Margin: This is calculated by dividing gross profit by revenue. A company with a moat typically maintains a consistently high gross margin above 40%. Conversely, a company without a moat would have a gross margin below 40% and exhibit volatility.

2) Sales, General, and Administrative (SG&A) Expenses: To evaluate this aspect, divide SG&A expenses by gross profit. Companies with a wide moat tend to have SG&A expenses consistently below 30%, indicating efficient operations. On the other hand, businesses without a moat have SG&A expenses exceeding 80% and display volatility.

3) Depreciation Expense: By comparing depreciation to gross profit, Buffett determines if a company needs significant capital expenditure assets to sustain its competitive advantage. A moat is indicated when depreciation consistently remains below 10%, while volatility and high ratios suggest the absence of a moat.

4) Interest Expense: This metric involves dividing interest expense by operating income. Companies with exceptional economics do not heavily rely on debt, so a moat is present when interest expense remains consistently below 15% of operating income. However, industries vary in this regard.

5) Income Tax Expense: Analysing the ratio of income tax paid to pre-tax income reveals if a company consistently pays the full amount of taxes. Businesses with a wide moat generate substantial profits, resulting in consistent tax payments close to the standard rate (e.g., around 21% in the U.S.). Negative or erratic income tax bills indicate a lower likelihood of having a durable moat.

6) Profit Margin (Net Margin): This is calculated by dividing net income by revenue. Companies with a moat typically achieve a net margin consistently above 20%. Profit margins below 10%, negative values, or volatility suggest intense competition. The range between 10% and 20% requires further consideration.

7) Capital Expenditures: Assessing capital expenditures relative to net income helps determine how much a company spends on assets. A moat is evident when capital expenditures remain consistently below 25%, as this allows for higher profits and greater returns to shareholders. However, it is essential to consider the average result over an extended period, as capital expenditures can vary significantly from year to year.

8) Return on Shareholders' Equity: This ratio is derived by dividing net income by shareholder equity. A moat is indicated when a company consistently achieves a return on equity above 15%, indicating effective reinvestment of profits. Returns below 10%, negative values, or volatility suggest a struggle with competition.

It's important to note three crucial points:
a) These rules of thumb are applicable when a company is fully optimized for profits (phase 4). They may not be effective during other phases.
b) Consistency is vital. Assessing a company's performance over multiple years and economic cycles provides a more accurate picture.
c) There are exceptions and nuances to these rules. Many of Buffett's significant investments do not fulfil every rule of thumb due to the complexities of investing and accounting. Nevertheless, these rules provide valuable guidance.