Sunday, May 27, 2012

The Little Book That Builds Wealth: Chapter 13

Morningstar's equity research director authored this book on identifying companies with competitive advantages. Dorsey separates competitive advantages into four categories, providing a framework for understanding how wide a moat a company really has. The book is full of examples of companies Dorsey believes have moats, and the reasons why their moats are likely to last - or not!

The author discusses more valuation tools to help the investor determine if a company is undervalued. Dorsey first discusses the price to sales ratio, but warns investors to avoid making comparisons between firms in different industries, as margins can vary substantially by industry.

The second tool Dorsey recommends is the price to book ratio. But it's important to understand the nature of the assets that make up book value. Specialized equipment or intangibles may have no redeeming value, whereas brand names that aren't included in book value may. Nevertheless, book value may have a lot of meaning for financial or real estate firms, for example.

Finally, Dorsey concludes this chapter by introducing the price to earnings and price to cash flow ratios. However, readers are warned that earnings and cash flow can be volatile from year to year, and therefore investors should look at a number of years worth of data in order to estimate what the company is likely to be able to earn in the future.

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