Why do some companies stand out among their rivals? Cash flow generation. Debt-free balance sheets. And significant and sustainable competitive advantage in the marketplace. But do you there is something else that separates companies that flourish from those who fail?

Economic Moat

This is the distinct advantage which make certain corporations flourish, a phrase popularized by investing legend and business magnate Warren Buffett. Economic moat is the character and longevity of a company’s competitive edge. For example, if Company XYZ has been generating excessive profits, its other counterparts would endeavor to get into the industry and do the same. A new competition will rattle their revenues as capital flows into the industry, unless Company XYZ has a distinct vantage.

Similar to a medieval castle, it is a barricade shielding a company and its profits from its competitors. Economic moat aims to protect everything inside their firm and their earnings from its operations. This is a huge element in a perfect economy, preventing competitors from stealing market share and profits.

But not all economic moats are created equally. Some moats are maintained for a long time, others disappear quickly. Knowing the difference between the two is tricky, as well as determining when a firm has an economic moat and when it does not.

Competitors must learn a moat does not exist if they can easily compete with little or no barriers. Conversely, corporations employ wide economic moats for long time periods; hence, reaping profits for several years.

The economic moat of a company is a qualitative – not quantitative – gauge of its capacity to drive their rivals away for a prolonged period. It is difficult to measure the moat quantitatively since it does not have a precise value, but significant qualitative factor in choosing stocks.

Creating Economic Moat

There are various ways a corporation forms an economic moat. Below are some of the most common ways of creating a moat.

Cost Advantage. A very effective economic moat, firms with significant cost advantage can lower the prices of any rivals trying to enter into their industry. This is done by either pressing them to leave the industry, or decelerating or halting its growth. Having feasible cost advantage can help a firm retain a very huge market share of their industry by crumpling any potential competitors.

Size Advantage. There are time being huge can become a corporation’s economic moat. A company attains economies of scale at a specific size when it can produce more units of a product or service on a bigger scale but with lower input expenses. Reducing these costs lowers overhead expenditures in financing, advertising, and production, among others.

High Switching Costs. If a firm has established its own mark, suppliers and customers can pay high switching costs should they opt to transfer their business with a new competitor. Rivals will endure a very hard time removing their market share from the industry leader because of such costs.

Intangibles. Certain things are worth a dime. A company’s intangible assets are some examples of economic moat, including brand recognition, government licenses, patents, and trademarks. Huge companies such as Coca-Cola, Nike, McDonald’s, and Apple enjoy strong brand name recognition because enables them to charge a premium for its products, bolstering their profits.

It takes time to distinguish economic moats and its effects are much easier to be observed in hindsight once a corporation has escalated. So investors, especially novice ones, must be mindful of economic moats. It is ideal to venture in growing firms since it has established a solid and wide moats. In other words, the longer a corporation can harvest profits, the greater the benefits for the entity and its shareholders.