How can you tell if a company has the kind of competitive advantage that can last for a long time? Some companies have hit products or have a turn up in profit due to current business cycles, yet they lose their market lead, their business focus, and struggle to regain earlier earnings power.
Following my first and second posts about Buffettology, next let's look over a business by the way its past earnings grew, and how much value they have added to shareholders. It isn't a predictive test to say what earnings and growth it will have one or even two years from now, but it can identify companies that have a durable competitive advantage.
REA Group (ASX: REA), owner of realestate.com.au, has had great growth since 2004. It started paying a dividend in 2009, and that has been growing nicely, too.
In 2004, earnings per share was 2.4 cents, and in 2013, 83.29 cents. Totaling all the earnings per share since 2004, it comes to a cumulative $3.37. During the same period, it paid out in dividends $1.27 a share. That means it retained $2.10 of earnings per share over the period, and one could argue that those retained earnings, reinvested in the company, added to its earning capability.
The difference between the 2.4 cents earnings per share in 2004 and 2013's 83.29 cents is about 81 cents. So from the $2.10 of total retained earnings per share, you could say that it generated the $0.81 increase in earnings per share. Simply dividing the $0.81 by $2.10, that would give you a 38.5% return.
You want to find companies that have returns over 12%, a business average for companies. This shows shareholder value is growing at an above average rate. By this, you could say that REA Group is a business with a durable competitive advantage. This would follow our general knowledge of the company as the number one real estate listings website in Australia.
Since the end of 2004, its share price has gone from $1.25 to $40.47, or up by a compounded annual growth rate (CAGR) of about 47%.
Using the same thinking and methodology, here are some more companies with a durable competitive advantage and a high theoretical model returns
Foolish takeaway
This is not the only test that you would do to decide to buy or not to buy a stock, but it helps you identify those companies that have stable, durable growth.
This test is to separate out the price-competitive companies that are more like commodity businesses where prices are discounted and competition is high.
