The goal of Patrick Dorsey's The Little Book That Builds Wealth is to help you find companies with long-term potential. We expect to pay more for goods that are more durable. That same principle applies to investing.

Pat Dorsey explains value in terms of a concept he calls economic moat. A company with an economic moat is a company that has a distinct advantage over its competition. Moreover, a company with a moat is worth more today because it will generate profits for a longer period into the future.

A company without a moat will see its return on capital decline as competitors seize more and more of its market share. If you buy companies with a moat you are better assured of buying a company that will increase its intrinsic value.

Companies with a wide moat are better able to bounce back from temporary troubles. Consider the mistake that Coca Cola made in misjudging consumer preferences with its launch of the new Coke. Realizing its mistake, Coke wooed back some of its customers by launching a non-carbonated Dasani water.

To assure greater success in investing, Dorsey recommends buying companies in industries that you readily understand.

Sheryl Sostarich 

In the business world, it is better to bet on the horse, not the jockey. The fact is that some businesses are structurally better positioned than others to survive. That is to say, it is the structural characteristics of a business that are hard for a competitor to duplicate for a long time into the future.

Bigger is not necessarily better as competitors arrive at the doorstep to eat away profits. It is not necessarily a large market share that insures a company's dominance. General Motors saw its market share diminish when the foreign makers surpassed them with technological innovation. IBM saw its market for mainframe computers erode when Dell Corporation and Apple Corporation began marketing the personal computer. Kodak lost its dominance when the industry changed from film processing to digital imaging.

In the orthopedic industry, smaller firms can generate high returns on invested capital just as well as the behemoth companies. Switching costs are high because each orthopedic device is implanted a little differently.

Don't be lured into thinking that a company has a moat when it doesn't. The most common mistaken moats are great products, strong market share, great execution and great management. These characteristics, while nice to have, do not insure that a company will be dominant in its industry.

Instead, you should be on the lookout for:

1. Companies with a brand, patent or license that sell products or services that can't be matched by competitors.

2. Companies that sell products or services that have a high switching cost.

3. Companies with a strong network that can lock out competitors for a long time.

4. Companies that are the low-cost producer.

Sheryl Sostarich

Intangible assets are not always a sure sign of a company with an economic moat. A brand that doesn't generate a return in the form of pricing power or repeat business isn't creating a competitive advantage.

The question to ask is: Is the company able to charge a premium relative to the competing products? Suppose you are wanting to purchase a DVD player. Would you buy the Sony label over the Philips or Samsung or Panasonic labels if the features of the DVD players are quite similar? If you are like most consumers of electronic products, you would buy the least expensive brand.

Brand name, by itself, is not enough to cause consumers to choose the Sony brand. It's hard to brand a true commodity product. A brand name can cause a consumer to limit his or her search to a select few brands, but it doesn't necessarily give a company pricing power.

Companies have to continually produce products that are high quality and durable to stay ahead of the competition. That is to say, brands can fall out of favor, patents can be challenged and licenses can be revoked.

Companies whose futures hinge on a single patented product are at high risk of losing their competitive advantage. One area where regulations change quite abruptly is in the pharmaceutical industry. Better products are engineered to obsolete those products currently on the market.

Brand name drugs lose their exclusive status as they come off patent and generic formulas come into the market. A company who once had a monopoly on the market is shuffled to a second class ranking.

A medical device company can spend millions of dollars on research and development and have to write off the entire investment if their products don't receive regulatory approval. Similarly a regulatory agency can take away competitive advantage by approving a device of a competitor company that is a better treatment for the disease state.

Intangible assets, though powerful at promoting brand awareness, do not guarantee a competitive advantage.

Sheryl Sostarich

Pat Dorsey asks his readers, when was the last time you changed banks? When he checked with several bankers, Dorsey found out that the average turnover for deposits is around 15 percent, which implies that the typical customer keeps his or her bank account for six to seven years.

Switching bank accounts can require a lot of extra paperwork as well as force the hassle of changing direct deposit or bill pay arrangements. Banks like Wells Fargo go a step further -- once they sign a client to a checking account, they try to cross sell their investment, insurance, and home mortgage products.

Sometimes the high costs of switching are enough to keep customers from buying a competitor's products. The goal is to build a base of loyal customers and hold on to long-standing relationships.

To hang onto its compeitive advantage, a bank or money management group is hard pressed not to make any mistakes. The mutual fund scandals a few years ago unequivocally hurt the reputations of several fund families when many clients chose to sever the relationship regardless of the cost.

Sheryl Sostarich

Businesses that benefit from the network effect are very similar -- the value of their product or service increases with the number of users.

The rewards and perks that American Express offers help it compete with other credit cards. Yet, if the card wasn't accepted by both the large and the small merchants, it wouldn't be nearly as popular. The huge network of merchants is what gives American Express a competitive advantage.

Networked businesses are natural monopolies and oligopolies. That's because the value of a product or service increases with the number of people using it. The dominant networkers eventually squeeze out the weaker players.

The transportation sector might at first sound dull but how does 40 percent returns on capital combined with 20 to 30 percent growth in the last decade sound to you? C.H. Robinson is a trucking broker who matches manufacturers and wholesalers with trucking operators to keep those over-the-road semis as full as possible. C.H. Robinson is in the business of building relationships between the nation's producers and transporters.

Similarly, Expeditors International has built an extensive branch network. It buys cargo space on planes and ships and also handles customs, tariffs, and warehousing between the point of origin and the point of departure.

It would be hard to launch a sofware company that could come close to competing with Microsoft. Just about every packaged PC is loaded with the Windows operating system. And once you have the basic package, you are going to need the upgrades.

Sheryl Sostarich

Companies can dig moats around their businesses by having sustainable lower costs than the competition. Cost advantages are achieved in a number of ways  -- through cheaper processes, better locations, with unique assets and greater scale.

Southwest Airlines flew only one type of jet, minimized expensive ground time and cultivated an employee culture that rewarded thrift. Southwest's point to point route structure made it hard for the majors to feed profitable buisness and international passengers through their expensively maintained hubs. Southwest is a no-frills carrier, meaning no separate classes and no assinged seats. Southwest secured ruway slots at second-tier airports and upgraded its fleet so it operates with a minimum of high maintenance, older aircraft.

Posco dominates the Korean steel market, with a 75% stake in the country's production. Although Posco has to import raw material its central production plant is next door to the automotive and shipbuilding plants. Steel rolls can be transported for a very low cost. Posco is within a day's shipping time from China, making it the lowest cost supplier.

Compass Minerals has a lock on the market for rock salt (used in deicing the highways). Compass owns a quarry in Ontario with 100 feet of minable rock. Compass can ship the mined rock via navigable rivers and canals and provide a steady souce of mineral rock to the Upper Midwestern states.

Sheryl Sostarich

If investing were as simple as identifying companies with an economic moat, making money in the stock market would be a no-brainer. The truth is, the price you pay for a stock is critically important to your furture investment returns.

Every company is slightly unique due its growth rate, its return on capital, and the strength of its competitive advantage. The value of a company is tied to its future performance, which is hard to forecast.

What you need to ask before you buy -- Is the current price lower than the most likely value of the business?

This means that you need to look at past performance to decide what is a realistic growth rate going forward. Past performance won't tell us whether furture performance will be better or worse, but it is a reasonable starting point. We must rely on ourselves to make an educated guess how we think a stock will perform.

There is a simple answer to the question What is a company worth? A stock is worth the present value of the free-cash it will generate in the future.

Building on this concept, there are four factors that determine the value of a company:

1. Risk -- Will the furture cash flows materialize?

2. Growth -- How large will those cash flows be?

3. Return on capital -- How much investment is needed to keep the business humming?

4. Economic moat -- For how long can the business generate excess profits?

It's important to analyze the price-earnings ratio before you buy. Are the shares trading for more or less than their historical average? The worst mistake an investor can make is to overpay for growth.

It's hard work to estimate a company's moat, but who doesn't like getting a deal?

Sheryl Sostarich

The three most important multiples for valuing a stock are price to sales, price to book, and price to earnings.

The price to sales ratio is particularly useful for cyclical companies and companies with temporarily negative earnings. A dollar of sales can be worth a little or a lot, depending on how profitable the company is. Dorsey strongly advises against using price to sales ratios to compare companies in different industries. You'll end up thinking that the lowest margin companies are all great bargains while the high margin companies are too expensive.

Retailers typically have low price to sales ratios whereas pharmaceutical companies typically have high price to sales ratios. If you think you've identified a low margin company in line with similar low margin companies and you believe the company can cut expenses to boost profitability, you might have identified a bargain.

Again, be careful. Companies who, in the past, have reported fat margins, but who currently have low price to sales ratios, might be trading at a discount because other investors perceive the decline as permanent.

The second common multiple is the price to book ratio. The key to using the price to book ratio to value stocks is to understand what book value represents. For a manufacturing firm, book value represents the assets that generate revenue. That is, the hard assets like plant, equipment, and inventories. For a service or technology company, the revenue-generating assets are people, ideas, and processes, none of which are incorporated in book value.

Excluding Bear Stearns and now Lehman Brothers, the assets of a financial services company are typically very liquid and easily valued. That means that the book value of a financial services company is a pretty accurate measure of true tangible value. A low price to book value for a financial services company is a potential red flag, indicating that there might be bad loans that will need to be written down.

The key to judging whether the price-earnings ratio is reasonable is to look at how the company has performed in good and bad economies. Companies with a wide moat, high returns on capital, and a bright outlook might deserve to be trading at a premium P/E ratio.

Company ratios are an important tool in valuation but they need to be looked at in context with the ratios of companies in the same industry. By looking at several ratios, you'll be better able to add companies to your portfolio at the right price.

Sheryl Sostarich