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

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by: Accelerating Dividends

Summary

I revised 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 revised rating system improved in measuring a company's moat, I did a correlation analysis comparing my ratings to Morningstar's.

There was no improvement between the revised version and the original version. They appear to be measuring different things.

I discuss why optimism remains for the revised rating system and how it might be better served as a measure of a company's financial strength leading to outperformance.

Moat, economic moat, competitive advantage

Introduction

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 using data that is more readily available and that could be free. After I came across the book "Warren Buffett and the Interpretation of Financial Statements," I used the ratios mentioned in the book as well as a few others from SA author Jae Jun and quantified them by creating a Likert Scale. In the article I published here on SA titled "Can 20 Financial Ratios Measure A Company's Moat Just Like Morningstar?," I presented my first iteration of the moat rating system, which I called AD.

The first iteration used a three-point scale where companies could score a 1, 3, or 5 on each of the 20 financial ratios. The maximum score that a company could achieve was 100. I then tested the ratings between the AD moat rating system and Morningstar using a sample of 98 dividend growth stocks. The results were not as I had hoped as I found only 54% agreement between the two rating systems, which is obviously too low. In the academic literature, a minimum of 75% is generally accepted. I did find that there were some improvements I could make to the AD moat rating system. The purpose of this article is to present the findings of the revisions I have made.

Methodology

Morningstar's system measures the strength of a company's moat based on five attributes which are Network Effect, Intangible Assets, Cost Advantage, Switching Costs and Efficient Scale. To learn more about each, you can find the source material here.

There were several errors that I found when evaluating the AD rating system. The first was the three-point scale. Each company could score no lower than 1 on each of the 20 ratios, which meant that each company started with 20 points. This lead to issues such as skewness because it meant that a company needed to score only 10 additional points before it went from a no moat rating to a narrow moat rating. The second issue was the cutoffs for each moat rating. The cutoffs were not based on statistical evidence such as the standard bell curve.

In order to deal with the first issue, I revised the scoring scale to a typical Likert Scale using values from 0 to 5. The following table presents the ratios, the explanation of each and the scoring system, which I will now call ADv2:

WHAT TO LOOK AT

EXPLANATION

SCORING

0

1

2

3

4

5

Gross Profit Margin

= Gross Profit / Total Revenue

< 20% = No sustainable competitive advantage

<20%

20-29%

30-39%

40-49%

50-59%

>=60%

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

>100%

<=100%

<=50%

<=30%

<=20%

<=10%

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 has 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.

>15%

<=15%

<=10%

<=5%

<=4%

<=2%

Interest Expenses

= Interest Expenses / Operating Profit

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

>100%

<=100%

<=50%

<=15%

<=10%

<=5%

Net Earnings

= Net Income / Total Revenues

< 10% = in highly competitive business

<10%

>=10%

>=15%

>=20%

>=25%

>=30%

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.

Strong declining trend

Erratic or declining trend

Inconsistent or flat trend

Inconsistent but upward trend

Consistent upward trend with 2-3 dips

Strong consistent upward trend with 1 dip

Inventory

=10 Year Net Inventory and 10 Year Net Income

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

Both strongly declining

Both slightly declining

Net Income declining and inventory flat

Net Income rising and inventory declining or both flat

Net Income rising and inventory rising slowly

Both rising strongly

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

>100%

<=100%

<=50%

<=20%

<=10%

<=5%

Return on Assets (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%

>=5%

>=10%

>=15%

>=20%

>=30%

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.

>100%

<=100%

<=70%

<=40%

<=30%

<=20%

Current Ratio

= Total Current Assets / Total Current Liabilities

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

<0.80

>=0.80

>=0.90

>=1.0

>=1.5

>=2

Long Term Debt

= Total Long-Term Debt / Net Income

Little to no long-term debt load for 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.

> 6 years

<= 6 years

<= 5 years

<= 4 years

<= 2 years

<= 1 years

Debt to Shareholders Equity Ratio

Debt to Shareholders Equity Ratio = Total Liabilities / Treasury Share Adjusted Shareholders Equity

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

> 1.0

<= 1.0

<= 0.90

<= 0.80

<= 0.75

<= 0.70

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.

No absence

2-year absence

4-year absence

6-year absence

8-year absence

10-year absence

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 good indicator

5-year CAGR <= 1%

5-year CAGR >= 1%years

5-year CAGR >= 5%

5-year CAGR >= 10%

5-year CAGR >= 15%

5-year CAGR >= 20%

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.

|Adjusted ROE - ROE| > 20%

|Adjusted ROE - ROE| <= 20%

|Adjusted ROE - ROE| <= 15%

|Adjusted ROE - ROE| <= 10%

|Adjusted ROE - ROE| <= 5%

|Adjusted ROE - ROE| <= 2%

Capital Expenditures

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

< 25% likely has durable competitive advantage

> 50%

<= 50%

<= 40%

<= 25%

<= 20%

<= 15%

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

10-year avg. < 5%

10-year avg. >= 5%

10-year avg. >= 10%

10-year avg. >= 15%

10-year avg. >= 20%

10-year avg. >= 25%

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 (RV), the company has no competitive advantage and if the EPV is below, the company is failing to capitalize on its earnings potential.

EPV is neg. or over 2x RV

EPV 2x< RV

EPV 1.5x< RV

EPV = RV

EPV 1.5x> RV

EPV 2x> RV

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.

< 25%

>= 25%

>= 30%

>= 40%

>= 50%

>= 60%

In order to address the cut off issue, I wanted to follow the normal bell curve. In case you have forgotten what that is, here is a picture:

Source: Dr. Nicholas C. Nicholas

The center (depicted as the 50% mark) contains the highest number of values (which is found by calculating the mean) or could be the highest number of occurrences (which is found by calculating the mode). Each outcome is then measured within a given range of possibilities. Each possibility is measured out by a standard deviation. As a rule, 68% of the area under the curve falls within 1 standard deviation, 95% within 2 standard deviations and 99.7% within 3 standard deviations. Many common attributes follow normal distributions with few members at the high and low ends and most falling in the middle.

In order to complete my analysis, I used the same sample from my first article. I began by selecting 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. Using the ADv2 moat rating system, I calculated each company's score. I then calculated the mean of the sample which was 53 (which was also the median). The standard deviation of the sample was 13. Therefore, companies that scored a 66 or above were labeled "wide" moat in order to keep with Morningstar's rating labels. Companies that scored between 40 and 65 were labeled "narrow" and companies that scored below 39 were labeled "none."

Results

Below are the companies in the sample and the moat ratings from Morningstar and ADv2:

Company

Ticker

Morningstar Rating

ADv2 Rating

ADv2 Label

Apple

(NASDAQ:AAPL)

Narrow

66

Wide

AbbVie, Inc.

(NYSE:ABBV)

Narrow

58

Narrow

Archer Daniels Midland

(NYSE:ADM)

None

39

None

Automatic Data Processing

(NASDAQ:ADP)

Wide

57

Narrow

Amgen

(NASDAQ:AMGN)

Wide

59

Narrow

Air Products and Chemicals

(NYSE:APD)

Narrow

56

Narrow

Becton, Dickinson and Company

(NYSE:BDX)

Narrow

31

None

Cardinal Health

(NYSE:CAH)

Wide

46

Narrow

Caterpillar

(NYSE:CAT)

Wide

26

None

Cracker Barrel Old Country

(NASDAQ:CBRL)

Narrow

71

Wide

Church & Dwight

(NYSE:CHD)

None

59

Narrow

C.H. Robinson Worldwide

(NASDAQ:CHRW)

Wide

65

Narrow

Colgate-Palmolive

(NYSE:CL)

Wide

66

Wide

Clorox

(NYSE:CLX)

Wide

52

Narrow

Comcast Corp.

(NASDAQ:CMCSA)

Wide

40

Narrow

Cummins

(NYSE:CMI)

Narrow

62

Narrow

Costco Wholesale

(NASDAQ:COST)

Wide

49

Narrow

Canadian Pacific Railway

(NYSE:CP)

Wide

44

Narrow

Cisco

(NASDAQ:CSCO)

Narrow

63

Narrow

CSX Corp.

(NYSE:CSX)

Wide

47

Narrow

CVS Health Corp

(NYSE:CVS)

Wide

45

Narrow

Chevron

(NYSE:CVX)

Narrow

40

Narrow

Deere

(NYSE:DE)

Wide

27

None

Disney

(NYSE:DIS)

Wide

55

Narrow

Emerson Electric

(NYSE:EMR)

Wide

51

Narrow

Enbridge, Inc.

(NYSE:ENB)

Wide

17

None

Fastenal Co.

(NASDAQ:FAST)

Wide

73

Wide

Foot Locker, Inc.

(NYSE:FL)

Narrow

65

Narrow

Flowserve Co.

(NYSE:FLO)

None

51

Narrow

General Dynamics

(NYSE:GD)

Wide

52

Narrow

General Electric

(NYSE:GE)

Wide

30

None

Gilead

(NASDAQ:GILD)

Wide

87

Wide

General Mills

(NYSE:GIS)

Narrow

35

None

Genuine Parts Company

(NYSE:GPC)

Narrow

59

Narrow

W.W. Grainger, Inc.

(NYSE:GWW)

Wide

60

Narrow

Hasbro

(NASDAQ:HAS)

Narrow

63

Narrow

Home Depot

(NYSE:HD)

Wide

59

Narrow

Honeywell International

(NYSE:HON)

Wide

49

Narrow

The Hershey Co.

(NYSE:HSY)

Wide

51

Narrow

IBM

(NYSE:IBM)

Narrow

56

Narrow

Intel

(NASDAQ:INTC)

Narrow

67

Wide

Illinois Tool Works

(NYSE:ITW)

Narrow

60

Narrow

Johnson & Johnson

(NYSE:JNJ)

Wide

70

Wide

Kellogg Co.

(NYSE:K)

Narrow

28

None

KLA-Tencor Corp.

(NASDAQ:KLAC)

Wide

66

Wide

Kimberly-Clark

(NYSE:KMB)

Narrow

34

None

Coca-Cola

(NYSE:KO)

Wide

49

Narrow

Lockheed Martin

(NYSE:LMT)

Wide

50

Narrow

Lowe's Co.

(NYSE:LOW)

Wide

45

Narrow

LyondellBasell Industries

(NYSE:LYB)

Narrow

62

Narrow

McDonald's

(NYSE:MCD)

Wide

55

Narrow

Medtronic

(NYSE:MDT)

Wide

52

Narrow

McCormick

(NYSE:MKC)

Wide

53

Narrow

3M

(NYSE:MMM)

Wide

60

Narrow

Altria

(NYSE:MO)

Wide

59

Narrow

Microsoft

(NASDAQ:MSFT)

Wide

55

Narrow

Nike, Inc.

(NYSE:NKE)

Wide

73

Wide

Norfolk Southern

(NYSE:NSC)

Wide

38

None

Realty Income

(NYSE:O)

None

43

Narrow

Omega Healthcare

(NYSE:OHI)

Narrow

42

Narrow

Owes & Minor, Inc.

(NYSE:OMI)

None

51

Narrow

Occidental Petroleum

(NYSE:OXY)

Narrow

45

Narrow

PepsiCo

(NYSE:PEP)

Wide

44

Narrow

Procter & Gamble

(NYSE:PG)

Wide

43

Narrow

Polaris Industries

(NYSE:PII)

Wide

66

Wide

Philip Morris

(NYSE:PM)

Wide

62

Narrow

Philips 66

(NYSE:PSX)

Narrow

56

Narrow

Qualcomm

(NASDAQ:QCOM)

Narrow

71

Wide

Ritchie Brothers Auctioneers

(NYSE:RBA)

Wide

66

Wide

Rockwell Automation, Inc.

(NYSE:ROK)

Wide

58

Narrow

Ross Stores, Inc.

(NASDAQ:ROST)

Narrow

71

Wide

Raytheon Co.

(NYSE:RTN)

Narrow

56

Narrow

Starbucks

(NASDAQ:SBUX)

Wide

70

Wide

JM Smucker Co.

(NYSE:SJM)

Narrow

39

None

Southern Company

(NYSE:SO)

Narrow

30

None

Seagate

(NASDAQ:STX)

None

45

Narrow

Stryker Corp.

(NYSE:SYK)

Wide

60

Narrow

AT&T

(NYSE:T)

Narrow

29

None

Target

(NYSE:TGT)

None

47

Narrow

TJX Companies, Inc.

(NYSE:TJX)

Narrow

69

Wide

Tyson Foods

(NYSE:TSN)

None

45

Narrow

Toro Co.

(NYSE:TTC)

Wide

67

Wide

Texas Instruments

(NYSE:TXN)

Wide

63

Narrow

Union Pacific

(NYSE:UNP)

Wide

52

Narrow

United Parcel Service, Inc.

(NYSE:UPS)

Wide

54

Narrow

United Technologies

(NYSE:UTX)

Wide

50

Narrow

Visa

(NYSE:V)

Wide

67

Wide

VF Corp.

(NYSE:VFC)

Wide

66

Wide

Valero Energy

(NYSE:VLO)

Narrow

53

Narrow

Verizon

(NYSE:VZ)

Narrow

37

None

Walgreens Boots Alliance

(NASDAQ:WBA)

None

53

Narrow

Wisconsin Energy

(NYSE:WEC)

Narrow

33

None

Whole Foods Market Inc.

(WFM)

Narrow

65

Narrow

Wal-Mart

(NYSE:WMT)

Wide

49

Narrow

Wyndham Worldwide Corp.

(NYSE:WYN)

Narrow

38

None

Xilinx, Inc.

(NASDAQ:XLNX)

Narrow

67

Wide

Exxon Mobil

(NYSE:XOM)

Narrow

39

None

Yum! Brands, Inc.

(NYSE:YUM)

Wide

45

Narrow

The following table shows the frequency of each rating. The results show much less agreement using the ADv2 rating system than the first iteration of the AD moat rating system when compared to Morningstar's ratings. Overall, there were 30 companies, or 30.61%, where the ADv2 and Morningstar rating systems came to the same conclusion. This is less than the 54% agreement that was achieved using the AD rating system. This decrease in agreement is incredibly disappointing. The following table presents the number of companies that each rating system measured as have no, narrow or wide moats.

None

Narrow

Wide

MORNINGSTAR

9

35

54

ADv2

17

62

19

AD

0

38

60

The ADv2 rating system has found that 17 companies have no moats, which appears to have corrected the issue where the AD rating system found that none of the companies were rated as having no moat. Many of the companies that were found to have a wide moat in the AD rating system were now found to have a narrow moat in the ADv2 rating system.

Comparing the ADv2 and Morningstar results shows that there were 15 companies, or 15.31%, where the ADv2 system rated the moat higher than Morningstar and there were 53 companies, or 54.08%, where the ADv2 system rated the moat lower than Morningstar.

Now that we have found that there is a great deal of discrepancy between the rating systems, the question that remains to be answered is how much. How many instances for example does the Morningstar rating system find a wide moat and the ADv2 rating system find no moat? The following table presents the cross tabular results comparing both rating systems:

ADv2 Rating

MORNINGSTAR Rating

None

Narrow

Wide

None

1

11

5

Narrow

8

17

37

Wide

0

7

12

This table provides us with some interesting findings. For example, the Morningstar rating system found that five companies (which were CAT, DE, ENB, GE and NSC) had wide moats while the ADv2 rating system found that they had no moats. In another example, the ADv2 rating system found that seven companies had wide moats (which were AAPL, CBRL, INTC, QCOM, ROST, TJX and XLNX) while Morningstar found that they had narrow moats. When looking at the companies in these two examples, there is some obvious points that stand out. In the case of NSC, there is not going to be some person who upstarts his own railroad tomorrow. In terms of infrastructure, NSC should be considered as having a wide moat.

In order to measure the relationship (or goodness of fit) and statistical significance, I used the Chi-Square test because the scores for Morningstar are considered categorical and you always need to go on the lowest level of your data. The ADv2 scores are ratio (highest level), but were converted into categorical in order to compare it with Morningstar.

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):

X 2(2, N = 98) = 26.76, p < .0001, Cramer's V = 0.3695

The Chi-Square test returns a significant difference between the Morningstar and the ADv2 rating systems. It is so strong (p <.0001) that there is no likelihood that the findings are due to chance. We must also look at the Cramer's V which measures the strength of the relationship between the two rating systems. A 0.3695 is considered a very strong relationship. My interpretation of these findings is that there is a significant difference between the two rating systems in that they are independent of each other and measuring different things particularly given the strength of the relationship between the two variables.

Conclusion

I believe this a great step forward in the development of this system. Although the results of the ADv2 rating system do not appear to present that picture, I will explain why I have some optimism. The first is because the ADv2 rating system made some positive steps by having an appropriate distribution using the mean of the scores and a standard deviation to separate the three categories of moats. The second is because one of the objectives was to correct the issue of having zero companies rated with no moat.

Why I believe there is still hope in this system is because I feel that the mean and the standard deviation could change and become more refined with a larger sample size. We have to remember that the reason why many dividend growth investors choose these companies is because they are some of the best of the best. If I assessed a larger sample from the CCC list prepared by David Fish which included some weaker companies or less known names (perhaps more challengers), the standard deviation could shrink slightly, or the mean may move closer to 50 which could increase the number of wide moat companies that are currently assessed as a narrow moat by the ADv2 system. However, one must also remember that the opposite is also possible.

SA member Fernando Soriano made a comment in my previous article on the AD rating system that when he back tested the companies that the system rated as a wide moat, he found that they had outperformed the market as measured using the S&P 500 (NYSEARCA:SPY). If these ratios fail to assess the strength of a company's moat, perhaps they can assist in evaluating the financial strength of a company and identify those who could outperform the market. Since the Chi-Square came back with a significant difference, perhaps the actual difference is the system's ability to measure the financial strength of a company rather than its moat. It is something that I believe is worth a try in evaluating, so stay tuned to an initial assessment of that angle.

Thanks for reading.

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Disclosure: I am/we are long LYB, ABBV, AMGN, CAH, HAS, OHI, SBUX, T, WYN.

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.