Saturday, May 26, 2012

The Little Book That Builds Wealth: Chapter 12

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!

Though a great deal of emphasis has been placed thus far on identifying companies with moats, investing is not as simple as buying the companies with the largest moats. This is because the price you pay for a stock is critically important to your future investment returns.

Valuing a company is difficult, as a company's value is tied directly to its future economic performance, which is unknowable! Instead of figuring out what a company is worth exactly, therefore, Dorsey argues that all that is required is determining that the company is trading for less than what it's worth.

To do this, Dorsey recommends estimating the company's current free cash flow and reverse-engineering the growth rate the market is implying for the company based on the company's market price. If your growth rate estimate is larger than that of the market, it may make sense to buy.

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