Not all moats are the same. Some moats are wider but not as durable, while others might be durable but have little growth opportunities. The 3 things that determine the attractiveness of a moat and how much the business is worth are its return on capital, durability, and reinvestment opportunities. 

Return on Capital

Return on capital (ROC) is how much a company can produce for every dollar invested. No moat companies can only earn an average ROC over their lifetime. That is to say, their ROC is the same as their cost of capital. You can think of the cost of capital as the minimum amount a company must earn to compensate for the risk of running the business. Most professionals use the CAPM formula to calculate the cost of capital. The alternative is hurdle rate or opportunity cost. Your hurdle rate is your next best idea. 

Most companies can only produce average ROC because of competition. A business that has high profitability (high ROC) attracts new competitors. Competitors increase supply, drive down the price, and eliminate the profits that attract them in the first place. On the other hand, companies with a moat can consistently produce a return above their cost of capital because of their ability to control supply. This excess return also called abnormal return or economic profit creates value for its shareholders. 

Just as you would prefer a savings account that pays a 3% interest over one with a 1% interest, a higher ROC is more attractive than a lower ROC. A 30% ROC is better than 20% ROC, which both are better than 10% ROC. The reason is that high returns reduce the time it takes to compound wealth. You can double your capital in half the time if a company produces 20% ROC (3.6 years) instead of 10% ROC (7.2 years). And from the point of valuation, 20% ROC is worth twice as much as 10% ROC. That’s the reason why high ROC companies tend to command higher P/E multiples. 

So the rule here is: The bigger the spread between the return on capital and its cost of capital, the more attractive it is.

Durability

If the return on capital measures the height of a moat, then durability measures the width of it: how long can a company sustain excess return before it reverts to average ROC. You can think of average return as the center of gravity that pulls companies towards it over time. Companies that don’t have a moat never escape that center point. Whereas for a moat company, how long it can resist the pull depends on its durability.   

Durability is more important than return on capital in determining the value of a moat for two reasons. 

The first is the power of compounding. A company that can maintain its durability to produce 15% ROC for the next 15 years will compound its value faster than one that has weaker durability and therefore can only do so for 10 years before hitting average return. Or put it differently, a company that produces 15% ROC for the next 30 years is worth more than a company that produces 30% ROC for 5 years before hitting 10% ROC for the remaining 25 years, all else equal. 

The second reason is that return on capital doesn’t paint the full picture. Companies with no moat can occasionally produce high returns due to tailwinds such as tight supply or strong demand. But those returns have little value because they’re unsustainable. If anything, it attracts more competitions that guarantee lower future returns. At the same time, companies such as startups can intentionally earn a poor or negative return as they invest heavily to grow their moat. Companies often forego short-term profitability to gain competitive advantages such as scale economies or network effects that allow them to earn a high return in the future.  

How a company allocates its capital determines whether it grows, sustains, or weakens its durability over time. Companies that can sustain or grow their durability are worth more than one that weakens over time. 

Reinvestment opportunity

Reinvestment opportunities measure a company’s growth potential by looking at its current market share over the total addressable market (TAM). 

Reinvestment opportunities determine the attractiveness of a moat because of the compound effect. An investment that can compound at a 20% return will be worth 6x more after a decade compared to 3x for one that’s unable to reinvest those returns. 

Companies with plenty of growth opportunities (reinvestment moat) are like a snowball rolling down a smooth hill. The more snow it gathers, the bigger it becomes, and the faster it rolls. On the other hand, companies with limited growth opportunities (legacy moat) are like a snowball on a rocky hill that gets halved every time it hits a rock. 

Companies have limited growth opportunities because they dominate a niche market or operate in a matured industry. As a result, these companies distribute the majority of their free cash flows as dividends or perform share buyback. Legacy moat companies can still be a good investment. Just that a reinvestment moat will be worth more and you should be willing to pay more for a company that has plenty of growth opportunities compared to one that doesn’t. 

Interconnectedness 

The ideal scenario is to own a company that possesses a durable business model with long growth potential while earning a high return on capital. But there are a few things to keep in mind. 

I mentioned earlier that companies like startups tend to prioritize durability and growth over current ROC. And that is all the more important in a winner-takes-all market. Therefore, just because a company earned a poor ROC in the past doesn’t mean it will continue to do so in the future or it isn’t in the process of building a moat. Companies that pursue low-cost strategies such as Costco and Amazon intentionally lower profitability (lower ROC) than they otherwise would to deter new entrants and increase durability. On the other end, watch out for companies that have high ROC with an eroding moat. 

Some companies are incentivised to maintain their growth rate and profitability at the expense of long-term durability. Clayton Christensen wrote in his book The Innovator’s Dilemma that in the 1960s, integrated mills were happy to cede market share in low margin products (i.e rebar market) to the more cost-efficient mini-mills to maintain their profitability. But over time, mini-mills were able to move upmarket as metallurgy improved and forced most integrated mills to shut down in the ensuing decades. 

Sometimes high growth opportunities might not be a good thing. A growth industry (think EV or E-commerce during the dot-com era) often attracts many new entrants that can lead to lower durability and ROC over time. And a company that has its durability weakened over time might have to reinvest more earnings to maintain its competitiveness rather than growing the business. 

How a company allocates capital affects its future return on capital, durability and reinvestment opportunities. Therefore, having a good understanding of the capital allocation strategy will give you a coherent view of the moat’s value.