Finding a great business is hard. But finding a great business that stays great—that’s the real challenge.
That’s where economic moats come in.
When I first started investing, I was obsessed with numbers. Spreadsheets, ratios, backtesting models.
But over the years, I realised something: the best companies don’t win just because of the numbers. They win because they’ve built something others can’t easily copy.
This is what an economic moat is. And if you want to grow wealth through investing, learning how to find an economic moat is essential.
Economic Moats Explained Briefly
Think of an economic moat like the moat around a medieval castle. It protects the castle from invaders.
In business, an economic moat protects profits from competitors. It’s the thing that stops rivals from stealing customers, copying products, or undercutting prices.
There are different types of moats—brand, network effects, cost advantages, switching costs, and efficient scale. I’ve written about them here.
But here’s what matters: a wide moat means the company can keep earning good returns on capital for a long time. That’s the kind of business you want to own.
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The Math Behind Moats
Now, let’s get to the numbers.
How is Economic Moat Calculated: ROIC vs WACC
Here’s how you measure an economic moat:
Return on Invested Capital (ROIC) minus Weighted Average Cost of Capital (WACC).
ROIC tells you how much return a company makes for every dollar it reinvests in the business. WACC is the cost of funding that investment—basically, what it pays its lenders and shareholders.
If ROIC is higher than WACC, the company is creating value. The bigger the spread, the stronger the moat.
This is the most important number in measuring moats.
The Magic Number: When Returns Beat Costs
Say a company has an ROIC of 20% and a WACC of 8%. That’s a 12% spread. That means for every $1 it reinvests, it makes 12 cents more than it costs to fund. Over time, this adds up—massively.
But here’s the catch: high returns attract competition. If the moat isn’t real, those returns get competed away.
So the question isn’t just: is ROIC > WACC?
The question is: how long can it stay that way?
How Much Can You Invest at This Winning Rate?
Some companies have high ROIC, but nowhere to reinvest profits. Others have lots of reinvestment opportunities but low returns.
The real magic happens when a company has both high ROIC and room to reinvest at those returns.
Think of it as planting seeds. If your seeds grow into big trees, and you’ve got endless land to plant more, you’ve got a money machine.
Porter’s 5 Forces: Finding Your Moat
Let’s break down where moats come from.
Harvard professor Michael Porter outlined five forces that shape industry competition. They’re still the gold standard for business analysis.
Supplier Power: When Suppliers Control the Game
If a few suppliers control key inputs, they can squeeze your margins. That’s bad.
Take airlines, for example. They rely on aircraft manufacturers (like Boeing, Airbus), who hold pricing power. Not a good place to be.
Buyer Power: How Customers Squeeze Your Profits
If customers can easily switch to another product, they’ll push your prices down.
Again, airlines. Customers just want the cheapest flight. They don’t care if it’s Airline A or B. That’s buyer power.
New Competitors: Entry Barriers That Protect You
The harder it is to enter an industry, the stronger the existing players.
Building a global payments network like Visa’s? Not easy. That’s why the Visa economic moat is one of the strongest in the world.
High entry barriers = good.
Substitute Threats: When Alternatives Kill Your Business
Substitutes are dangerous. Taxis didn’t think Uber was a threat—until it was too late.
If your product can be replaced by something cheaper, faster or more convenient, your moat is at risk.
Industry Rivalry: Why Similar Products Mean Price Wars
The more similar the products, the more companies fight on price.
Look at the smartphone industry. Every phone looks the same, does the same, and costs about the same. That’s why only the top players survive.
Market Control: The Concentration Game
Some industries are dominated by a few giants. Others are fragmented with thousands of players.
How Top Companies Dominate Industries
Companies with a large market share can set terms. They get better suppliers, better pricing, and better access to customers.
But don’t confuse market concentration with profitability.
What really matters is market share, not just market dominance.
Network Effects: When More Users = More Value
Here’s the holy grail of moats.
When a product becomes more valuable as more people use it, that’s a network effect.
Take Amazon’s economic moat. The more sellers join Amazon, the more buyers shop there. The more buyers come, the more sellers join. It’s a flywheel. And it’s very hard to stop.
Disruption: When Moats Crumble
Big companies don’t always stay big.
How Small Players Beat Big Companies
Clayton Christensen’s disruptive innovation theory explains this well. New players don’t beat giants by going head-to-head. They start small—serving the low end or unserved market with simpler, cheaper products.
By the time the incumbents notice, it’s too late.
Low-End vs New-Market Disruption
Low-end disruption targets existing customers with a cheaper solution.
New-market disruption creates entirely new customers. Think how smartphones replaced not just phones, but cameras, MP3 players and GPS devices.
Why Incumbents Often Lose to Simpler Solutions
Big companies are built to serve existing customers with higher margins. So they ignore low-end threats. They wait too long to respond.
Then they get steamrolled.
Vertical vs Horizontal: Structure Matters
When to Control Your Supply Chain
Vertical integration means owning the supply chain. Horizontal means outsourcing or partnering.
Tesla controls its battery production, software, and even distribution. That’s why it moves faster, builds better products, and earns better margins.
Tesla’s Vertical Integration Advantage
Tesla’s tight control means faster innovation. It doesn’t wait for suppliers. It doesn’t share margins. It owns the entire experience.
Ford’s EV Struggle with Horizontal Approach
Ford outsources key parts of its EV production. That slows it down. And eats into profits. That’s why it’s struggling to compete in EVs.
Structure matters.
How to Find an Economic Moat in Real Companies
Let’s look at real examples.
Amazon Economic Moat: Network Effects and Scale
Amazon has scale. It has a brand. It has data. And it has network effects. Sellers and buyers create value for each other. It’s self-reinforcing.
That’s a textbook economic moat.
Visa Economic Moat: Payment Network Dominance
Visa connects billions of cards to millions of merchants. The more people use it, the more merchants want to accept it. The more merchants accept it, the more people use it.
That’s an unbeatable scale. And massive switching costs.
Red Flags: When Moats Are Weakening
Watch for rising costs, slowing growth, and declining margins. Watch for customer churn. When competitors start copying with success, the moat is under threat.
Measuring Your Investment
Calculate the ROIC-WACC Spread
Always measure the spread. Look at ROIC and WACC over 5-10 years. Is it stable? Rising? Falling?
A wide, stable spread means a strong moat.
How Long Can Competitive Advantages Last?
Even great moats don’t last forever. Eventually, others copy. Best practices spread. Margins compress.
The key is owning the moat before it shrinks.
When High Returns Attract Too Many Competitors
Success breeds competition. That’s why durability matters. Can the company defend those high returns?
Simple Steps to Moat Analysis
Let’s keep this simple.
Quick Checklist for Evaluating Any Company
- ROIC consistently above WACC?
- Revenue and margins stable or rising?
- Network effects or cost advantages?
- High switching costs or strong brand?
- Industry entry barriers?
- Competitors struggling to catch up?
Common Mistakes Investors Make
- Mistaking short-term profits for durable moats
- Ignoring disruption from smaller players
- Over-relying on brand without pricing power
- Confusing market share with competitive edge
Final Thoughts: Moats Are Rare, But Worth the Hunt
The truth is, most businesses don’t have a moat. They survive, they grow a little, maybe even impress in one or two good years. But without a durable competitive edge, they eventually get eaten by the competition.
That’s why spotting economic moats early—and correctly—is one of the most powerful things you can do as an investor.
You don’t need to find dozens. Just a few great businesses with wide moats, earning high returns, and reinvesting at those returns for years to come.
And once you find them, hold on. Let them compound.
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