Four clues to the competitive moat at Taylor Wimpey (LON:TW.)

Most investors would agree that the best quality companies on the stock market often make the best investments. These are the kind of companies that are stable, growing, cash generative and are consistently able to make stunning profits year in year out.

Their ability to resist external threats and generate breathtaking profits is what makes these stocks so appealing. They consistently compound investment returns at above-average rates over the long term.

These stocks have a competitive edge as they have what billionaire investor, Warren Buffett, calls economic moats. Like medieval castles, their profits are fortified by impregnable business models.

In this article we will discuss exactly what makes these stocks so special - and we'll also take a look at Taylor Wimpey (LON:TW.) as a prime example. Taylor Wimpey, a UK based residential developer, which also has operations in Spain, is an adventurous, large cap stock listed on the FTSE 100. 

How can you tell whether a company has a moat?

Moats are desirable because they often guarantee a sustainable competitive advantage. But there are several ways that companies can get them. For example, they might have:

• Intangible Assets - Such as brands that customers love, valuable patents or regulatory approvals
• Switching Costs - It might be too costly, complicated or unnecessary for customers to look elsewhere
• Network Effects - When customers become part of a product it creates tremendously powerful businesses
• Cost Advantages - Superior processes and unique locations and assets make it hard for others to compete
• Great Scale - Large infrastructure and distribution networks are powerful barriers to entry in many industries
  

Has Taylor Wimpey (LON:TW.) got a moat?

When it comes to searching for companies with moats, some of the biggest clues actually lie in their financial statements. By looking at a small number of important ratios you can get an idea about the competitive strength and profit power in a business.

Here's what they are and why they are important - and how Taylor Wimpey stacks up against them:

1. High rates of Free Cash Flow - the measure of a thriving company.
   - A high ratio of free cash flow to sales can be a very positive sign. For Taylor Wimpey, the figure is an impressive 15.7%. 
2. High Return on Capital Employed - the measure of a company growing efficiently and profitably.
   - A 5-year average ROCE of more than 12 percent is a pointer to strong efficiency. For Taylor Wimpey, the figure is an eye-catching 18.8%.
3. High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
   - Taylor Wimpey has a 5-year average ROE of 18.9%. The company's ROE for this year is 20.6%, comfortably beating the industry median of 11.7%.
4. High Operating Margins (compared to peers) - the measure of a company with pricing power.
   - Taylor Wimpey has a 5-year average operating margin of 19.5%. What's even more remarkable is the company's operating margins this year compared to its peers, currently standing at 20.3% vs an industry median of just 7.14%. 
   

What does this mean for potential investors?

Some of the best quality stocks in the market have defensible models that can deliver high levels of shareholder returns over the long term. But there are no guarantees and it's important to do your own research. Indeed, we've identified some areas of concern with Taylor Wimpey that you can find out about here.