Can 20 Financial Ratios Measure A Company's Moat Just Like Morningstar?

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by: Accelerating Dividends
Summary

I developed a moat rating system based on multiple financial ratios found in the book “Warren Buffett and the Interpretation of Financial Statements”.

In order to determine whether my rating system was measuring a company’s moat, I did a correlation analysis comparing my ratings to Morningstar’s.

The correlation test could not be completed but an analysis on the agreement between the two found that 54% of the ratings given by each system was the same.

Moat, Morningstar, Accelerating Dividends, financial ratios measuring a company

A moat is a reference to a company's ability to protect its long-term earnings, market share and competitive advantages from its competitors. I was very interested in evaluating the strength of a company's moat on my own. Services such as Morningstar do evaluate the strength of a company's moat but it requires a premium subscription. I came across the book "Warren Buffett and the Interpretation of Financial Statements" in which the authors stated that:

It is the purpose of this book to explore Warren [Buffett's] two revelations - 1) How do you identify an exceptional company with a durable competitive advantage? 2) How do you value a company with a durable competitive advantage? - to explain how his unique strategy works, and how he uses financial statements to put his strategy into practice. A practice that has made him the richest man in the world.

I envisioned a straightforward and easy-to-understand book that would teach investors how to read a company's financial statements, to look for the same kinds of companies that Warren does. A book that not only would explain what a balance sheet and income statement are, but would point out what investors should look for if, like Warren, they are searching for a company that possesses a long-term competitive advantage." (Source: Warren Buffett and the Interpretation of Financial Statements)

Using elements from the book as well as some of the interpretation of SA contributor Jae Jun and his blog post, I quantified those elements in order to score a company using a 20 financial ratios with a 100-point scoring system to come up with a rating. My methodology in full can be found here.

One of the recurring comments I received from readers from the articles in which I have used this scoring method (here, here) was how well my method correlated with that of Morningstar. The purpose of this article is to conduct such an analysis.

ANALYSIS

Morningstar's economic moat rating is considered the "gold standard." The following is a description of how Morningstar evaluates a moat:

A company whose competitive advantages we expect to last more than 20 years has a Wide Moat, one that can fend off their rivals for 10 years has a Narrow Moat, while a firm with either no advantage or one that we think will quickly dissipate has no moat.

A company with an Economic Moat can fend off competition and earn high returns on capital for many years to come.

Here are some of the attributes that can give companies economic moats:

Network Effect. The network effect occurs when the value of a company's service increases for both new and existing users as more people use the service.

Intangible Assets. Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company's products, or allow the company to charge a significant price premium.

Cost Advantage. Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins.

Switching Costs. When it would be too expensive or troublesome to stop using a company's products, the company often has pricing power.

Efficient scale. When a niche market is effectively served by one or a small handful of companies, efficient scale may be present." (Source: Morningstar)

The following is what I used to measure a moat and my scoring system.

WHAT TO LOOK AT

WHAT TO CALCULATE

WHAT TO LOOK FOR

SCORING

Gross Profit Margin

= Gross Profit/Total Revenue

< 20% = No sustainable competitive advantage

5 = > 40%

3 = < 40%

1 = < 20%

SG&A

= SG&A/Gross Profit

If the value is below 30%, this is a strong indicator of a competitive advantage.

100% means a very competitive industry

5 = < 30%

3 = < 70%

1 = < 100%

Depreciation

= Depreciation & Amortization/Gross Profit

It is a measurement of financial efficiency. The ratio intimates the amount of income that is required to maintain the capital being used by the business. Company with the competitive advantage have a tendency to have a lower percentage. The lower the percentage, the stronger the ratio. < 5% is considered strong, > 15% means that the business may be wearing out its capital too quickly.

5 = Lowest %

3 = Middle %

1 = Highest %

Interest Expense

= Interest Expenses/Operating Profit

Durable competitive advantages carry little or no interest expense. Buffett's favorite consumer products have < 15%.

5 = < 15%

3 = < 50%

1 = < 100%

Net Earnings

= Net Income/Total Revenues

< 10% = in highly competitive business.

5 = > 20%

3 = < 20%

1 = < 10%

EPS

= Net Income/Average Outstanding Common Shares

or if the company has preferred stock then

= (Net Income - Dividends on Preferred Stock)/Average Outstanding Common Shares

10-year period showing consistency and upward trend. Erratic earnings are a negative sign.

5 = Consistent upward trend

3 = Inconsistent but upward trend

1 = Erratic or declining trend

Inventory

10-Year Net Inventory and 10-Year Net Income

Look for an inventory and net income that are on a corresponding rise.

5 = Both rising

3 = One rising, one declining

1 = Both declining

Net Receivables

= Net Receivables/Gross Sales

A company that consistently has a lower percentage of net receivables to gross sales than competitors has a competitive advantage.

5 = Lowest %

3 = Middle %

1 = Highest %

ROA

= Net Income/Total Assets

Higher return the better. but a really high ROA may indicate a vulnerability in the durability of the competitive advantage.

5 = > 20% or best among competitors

3 = < 20% or average among competitors

1 = < 10% or worst among competitors

Short-Term Debt

=Total Short-Term Debt/Cash and Cash Equivalents

Buffett shies from those who are bigger borrowers of short-term debt. If the short-term debt is greater than the cash and cash equivalents, the company could have poor financial health.

5 = < 50%

3 = < 75%

1 = >100%

Current Ratio

= Total Current Assets/Total Current Liabilities

Higher the ratio. the greater the company's ability to pay current liabilities.

5 = > 1.0

3 = < 1.0

1 = < 0.8

Long-Term Debt

= Total Long-Term Debt/Net Income

Little to no long-term debt load for the past ten years. Need little or no long-term debt to maintain operations. A company should be able to generate enough net income each year to pay back the long-term debt in 3-4 years.

5 = < 4 years

3 = > 4 years

1 = > 6 years

Debt to Shareholders' Equity Ratio

Debt to Shareholders Equity Ratio = Total Liabilities/Treasury Share Adjusted Shareholder Equity = (Treasury Shares*Neg 1) + Shareholders Equity

If the debt to shareholder equity ratio is < 0.80, it indicates that the company has a competitive advantage.

5 = < 0.80

3 = > 0.80

1 = > 1.0

Preferred Stock

10-Year Preferred Stock

Look for the absence of preferred stock because it is considered expensive money due to the fact that dividends paid on preferred stock are not deductible. Companies tend to avoid preferred stock if they can.

5 = 10-year absence of Preferred Stock

3 = Some history of Preferred Stock

1 = 10-year presence of Preferred Stock

Retained Earnings

10-Year Retained Earnings

Retained earnings from each year are added to the total of accumulated retained earnings. Rate of growth of retained earnings is a good indicator.

5 = Retained Earnings is increasing

3 = Retained Earnings is flat

1 = Retained Earnings is decreasing

Treasury Stock Effect on ROE

Adjusted ROE = Net Income/(Treasury Shares*Neg 1) + Shareholders Equity

Shares that are bought back can be held as treasury stock. This has the effect of increasing ROE. A high ROE is a sign of a competitive advantage; however, it can be engineered financially. Compare ROE with the adjusted ROE to determine if the ROE is generated by a strong business or financial manipulation.

5 = Adjusted ROE = > ROE (within 2%)

3 = Adjusted ROE < ROE (within 5%)

1 = Adjusted ROE < ROE (greater than 5% difference)

Capital Expenditures

= add 10 years of Total Cap Ex/add 10 years of Total New Income

< 25% likely has durable competitive advantage.

5 = < 25%

3 = < 50%

1 = > 50%

CROIC

= FCF/Invested Capital

Invested Capital = Shareholders' Equity + Interest Bearing Debt + Short-Term Debt + Long-Term Debt

> 15% consistently shows that the company has a strong competitive advantage.

5 = > 15%

3 = < 15%

1 = < 5%

Earnings Power Value (EPV)

=Adjusted Earnings*1/R

R = cost of capital (either weighted average cost of capital or a discount rate)

EPV score exceeds the net reproduction value.

If EPV = reproduction value, the company has no competitive advantage and if the EPV is below, the company is failing to capitalize on its earnings potential.

5 = EPV > Reproduction Value

3 = EPV = Reproduction Value

1 = EPV < Reproduction Value

Gross Profits/Total Assets (GPA)

= (Gross Revenues - Cost of Goods Sold)/Total Assets

This is an indicator that the company is generating profits using its existing assets. Look for GPA above 50% for the best results.

5 = > 50%

3 = > 25%

1 = < 25%

When you compare the two, it is obvious that they are measuring moats differently. An argument can be made that the rating in which Morningstar gives each company should be reflected in the company's financial statement whether it is strong with a wide moat or weak with no moat at all.

METHODOLOGY

In order to complete my analysis, I selected 100 dividend growth companies. Two were removed as they were financials and the structure of their financial statements prevented my rating method from scoring correctly. This left 98 companies in the sample. I obtained the moat rating from Morningstar and then completed the assessment of each company using my rating method. In the table below are the companies in the sample, the Morningstar rating and my own rating which I call AD.

Because Morningstar has three ratings (wide, narrow, none), I had to convert these ratings into a numerical scale (wide = 3, narrow = 2, none =1). Similarly, because my ratings come up with a score that can reach 100, I needed to categorize my ratings into a scale that is comparable with Morningstar's (AD score <29 = 1, 30-69 = 2, >70 = 3). The value of these scales is also found in the table below.

Company

Ticker

Morningstar Rating

AD Rating

Morningstar Scale

AD Scale

Gilead

(NASDAQ:GILD)

Wide

94

3

3

Fastenal Co.

(NASDAQ:FAST)

Wide

92

3

3

Johnson & Johnson

(NYSE:JNJ)

Wide

88

3

3

Qualcomm

(NASDAQ:QCOM)

Narrow

86

2

3

Starbucks

(NASDAQ:SBUX)

Wide

86

3

3

Apple

(NASDAQ:AAPL)

Narrow

84

2

3

Illinois Tool Works

(NYSE:ITW)

Narrow

84

2

3

LyondellBasell Industries

(NYSE:LYB)

Narrow

84

2

3

Visa

(NYSE:V)

Wide

82

3

3

Hasbro

(NASDAQ:HAS)

Narrow

82

2

3

Intel

(NASDAQ:INTC)

Narrow

82

2

3

Cracker Barrel Old Country

(NASDAQ:CBRL)

Narrow

82

2

3

Rockwell Automation Inc.

(NYSE:ROK)

Wide

82

3

3

3M

(NYSE:MMM)

Wide

80

3

3

Cummins

(NYSE:CMI)

Narrow

80

2

3

Texas Instruments

(NYSE:TXN)

Wide

80

3

3

Union Pacific

(NYSE:UNP)

Wide

80

3

3

McCormick

(NYSE:MKC)

Wide

78

3

3

Genuine Parts Company

(NYSE:GPC)

Narrow

78

2

3

Colgate-Palmolive

(NYSE:CL)

Wide

78

3

3

The Hershey Co.

(NYSE:HSY)

Wide

78

3

3

Disney

(NYSE:DIS)

Wide

78

3

3

Home Depot

(NYSE:HD)

Wide

78

3

3

Stryker Corp.

(NYSE:SYK)

Wide

78

3

3

Church & Dwight

(NYSE:CHD)

None

76

1

3

Clorox

(NYSE:CLX)

Wide

76

3

3

Altria

(NYSE:MO)

Wide

76

3

3

Amgen

(NASDAQ:AMGN)

Wide

76

3

3

W.W. Grainger Inc.

(NYSE:GWW)

Wide

76

3

3

United Technologies

(NYSE:UTX)

Wide

74

3

3

Automatic Data Processing

(NASDAQ:ADP)

Wide

74

3

3

McDonald's

(NYSE:MCD)

Wide

74

3

3

Cisco

(NASDAQ:CSCO)

Narrow

74

2

3

Raytheon Co.

(NYSE:RTN)

Narrow

74

2

3

Coca-Cola

(NYSE:KO)

Wide

72

3

3

PepsiCo

(NYSE:PEP)

Wide

72

3

3

Owes & Minor Inc.

(NYSE:OMI)

None

72

1

3

AbbVie Inc.

(NYSE:ABBV)

Narrow

72

2

3

IBM

(NYSE:IBM)

Narrow

70

2

3

Lockheed Martin

(NYSE:LMT)

Wide

70

3

3

Walgreens Boots Alliance

(NASDAQ:WBA)

None

70

1

3

Philip Morris

(NYSE:PM)

Wide

70

3

3

Emerson Electric

(NYSE:EMR)

Wide

70

3

3

Philips 66

(NYSE:PSX)

Narrow

70

2

3

Flowserve Co.

(NYSE:FLO)

None

70

1

3

General Dynamics

(NYSE:GD)

Wide

70

3

3

Honeywell International

(NYSE:HON)

Wide

70

3

3

Target

(NYSE:TGT)

None

68

1

2

Wal-Mart

(NYSE:WMT)

Wide

68

3

2

Tyson Foods

(NYSE:TSN)

None

68

1

2

CSX Corp.

(NYSE:CSX)

Wide

68

3

2

Exxon Mobil

(NYSE:XOM)

Narrow

66

2

2

Microsoft

(NASDAQ:MSFT)

Wide

66

3

2

Lowe's Co.

(NYSE:LOW)

Wide

66

3

2

Procter & Gamble

(NYSE:PG)

Wide

64

3

2

Valero Energy

(NYSE:VLO)

Narrow

64

2

2

Omega Healthcare

(NYSE:OHI)

Narrow

62

2

2

JM Smucker Co.

(NYSE:SJM)

Narrow

62

2

2

Medtronic

(NYSE:MDT)

Wide

62

3

2

Cardinal Health

(NYSE:CAH)

Wide

62

3

2

Costco Wholesale

(NASDAQ:COST)

Wide

62

3

2

Archer Daniels Midland

(NYSE:ADM)

None

62

1

2

Comcast Corp.

(NASDAQ:CMCSA)

Wide

62

3

2

General Mills

(NYSE:GIS)

Narrow

60

2

2

Chevron

(NYSE:CVX)

Narrow

60

2

2

Canadian Pacific Railway

(NYSE:CP)

Wide

60

3

2

CVS Health Corp.

(NYSE:CVS)

Wide

58

3

2

Yum! Brands Inc.

(NYSE:YUM)

Wide

58

3

2

Southern Company

(NYSE:SO)

Narrow

56

2

2

Occidental Petroleum

(NYSE:OXY)

Narrow

56

2

2

Realty Income

(NYSE:O)

None

54

1

2

Verizon

(NYSE:VZ)

Narrow

54

2

2

Air Products and Chemicals

(NYSE:APD)

Narrow

54

2

2

Norfolk Southern

(NYSE:NSC)

Wide

54

3

2

Wisconsin Energy

(NYSE:WEC)

Narrow

52

2

2

Becton Dickinson and Company

(NYSE:BDX)

Narrow

48

2

2

Caterpillar

(NYSE:CAT)

Wide

48

3

2

Deere

(NYSE:DE)

Wide

48

3

2

AT&T

(NYSE:T)

Narrow

46

2

2

Kimberly-Clark

(NYSE:KMB)

Narrow

44

2

2

General Electric

(NYSE:GE)

Wide

40

3

2

Kellogg Co.

(NYSE:K)

Narrow

40

2

2

KLA-Tencor Corp.

(NASDAQ:KLAC)

Wide

84

3

3

Nike Inc.

(NYSE:NKE)

Wide

88

3

3

Polaris Industries

(NYSE:PII)

Wide

82

3

3

Ritchie Brothers Auctioneers

(NYSE:RBA)

Wide

82

3

3

Ross Stores Inc.

(NASDAQ:ROST)

Narrow

78

2

3

Seagate

(NASDAQ:STX)

None

62

1

2

TJX Companies Inc.

(NYSE:TJX)

Narrow

80

2

3

VF Corp.

(NYSE:VFC)

Wide

86

3

3

Whole Foods Market Inc.

(WFM)

Narrow

80

2

3

Wyndham Worldwide Corp.

(NYSE:WYN)

Narrow

56

2

2

Xilinx Inc.

(NASDAQ:XLNX)

Narrow

86

2

3

Toro Co.

(NYSE:TTC)

Wide

84

3

3

United Parcel Service Inc.

(NYSE:UPS)

Wide

72

3

3

Foot Locker Inc.

(NYSE:FL)

Narrow

84

2

3

Enbridge Inc.

(NYSE:ENB)

Wide

38

3

2

C.H. Robinson Worldwide

(NASDAQ:CHRW)

Wide

76

3

3

The following table shows the frequency of each rating. The results show some rather impressive consistency between the two with the exception of companies that Morningstar has rated as having no moat. In this case, the AD evaluation never rated a single company as having no moat.

Upon further reflection, the reason being is that each question is scored with either a 1, 3, or 5. This means that each company begins each evaluation with a score of 20 because they currently do not score zeros. This means that a company only needs to score 10 additional points in order for it to reach a narrow rating. In statistical language, the rating system is skewed.

None

Narrow

Wide

MORNINGSTAR

9

35

54

AD

0

38

60

Although there appears to be some impressive consistency, a deeper analysis is warranted because the AD rating did not always agree with the Morningstar rating. Overall, 53 or 54.08% companies had the same rating, 17 (17.35%) companies had higher ratings by AD than Morningstar and 28 (28.57%) companies had lower ratings by AD than Morningstar.

There were four companies in particular where the AD rating system scored them as having wide moats when Morningstar rated them as having none. These companies were CHD, OMI, WBA and FLO. At no time was the reverse found where the AD rating system found no moat and Morningstar found a wide moat.

Overall, having just over 50% agreement is a little disappointing. The generally accepted minimum in academics is 75%.

The table below shows a summary of the larger table and helps explain my paragraph on agreement. The rating system for AD and Morningstar is provided and shows where each company scored when considering the AD rating over Morningstar.

So for example, when the AD rating was greater than or equal to 70, Morningstar rated the company as having a wide moat, which signifies that both systems were in agreement. However, Morningstar rated 23 companies as having a narrow moat when AD rated it as having a wide moat or a score greater than or equal to 70. Also, Morningstar rated 16 companies as having a wide moat whereas AD rated them as having a narrow moat.

MORNINGSTAR

AD

>=70

<=69, >=30

<=29

Wide

37

16

0

Narrow

23

5

0

None

0

0

0

In order to determine statistical correlation, there are several rules that need to be observed. First, a Chi-Square is the only test that can be used because the data is nominal in nature or the lowest level of central tendency (in other words very basic data). Second, in order to complete a Chi-Square, none of the values can be less than 5. Unfortunately, statistical correlation cannot be reliably assessed because the AD scale has a zero value as found in the second table. However, the test can still be run to provide an impression but it should not be considered valid or reliable.

Using the website vassarstats.net, I inputted the values found in the second table into their Chi-square calculator. The results were as follows (for you statistical buffs out there):

X2(2, N = 98) = 9.44, p < 0.01, Cramer's V = 0.2195

What is important here is the p score and the Cramer's V. The p score is less than 0.01 which means that it is statistically significant (remember my caveat above) and suggests that the findings are not due to chance. However, the Cramer's V finds that the association between the Morningstar and AD ratings is weak. This would be expected given that they are measuring a moat differently but may also be an indication of the strength of the AD rating system compared to Morningstar's.

CONCLUSION

I would judge this assessment as providing sufficient preliminary results. Although the statistical correlation test could not be reliably conducted, the amount of consistency between the Morningstar and AD ratings was good but the agreement overall needs to be improved by 25%.

In order to truly assess whether the AD rating system can measure a company's moat, I will be making some modifications. The most important modification will be how each ratio is scored. An expanded Likert Scale with scores ranging from 0 to 5 will be implemented. This is important in order to remove the skew that was detected and provide an absolute zero score. The range will be from 0 to 100. Due to an expanded scale, the rating of each criteria will also need to be expanded. This will likely provide a more thorough and detailed rating.

I haven't given up on this project just yet because I believe that there are still some avenues to explore. When I have completed my revisions, I will complete the test again and let you all know how it turned out. If it doesn't work the second time, I will not be able to say that my rating system is assessing the strength of a company's moat, but rather assessing the strength of its financial state.

Thanks for reading.

I hope you enjoyed this article. If you want to be notified when my future articles are published, please consider following me as a Seeking Alpha author by clicking the "Follow" button at the top of the article beside my name Accelerating Dividends.

Disclosure: I am/we are long GILD, SBUX, LYB, HAS, TGT, OHI, WYN, T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.