Investing Basics: P&G, King or Pretender?

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In the book Rule Breakers, Rule Makers, Motley Fool co-founder and CEO Tom Gardner lays out seven criteria for judging a company worthy of "rule maker" status, i.e., a company that's the undisputed king of its market space, making for an investment that can be confidently and profitably held onto for years.

The mighty Procter & Gamble (NYS: PG) released earnings for the quarter earlier this month. The market didn't react kindly (the share price dropped by about a dollar), but we Fools know better than to put all our faith in that wild child. Let's run the consumer-goods giant through the merciless rule-maker gauntlet and make our own determination.

1. Automatic for the people
In terms of a company with mass-market, repeat-purchase, low-priced goods, P&G is it. Its iconic brands, including Pampers, Tide, Gillette, and Crest, are purchased countless times a day by consumers around the globe. Along with Colgate-Palmolive (NYS: CL) and Clorox (NYS: CLX) , P&G practically defines this rule-maker category.

2. Pricing power
Gross margin indicates brand strength and pricing power, and at 48.3%, P&G's is very healthy in the latest quarter, though ideally we like to see 60% or more.

3. The top line
Who doesn't like to see revenue increases? P&G picked up $1.9 billion in new revenue for the quarter, giving growth of 10.2% and surpassing our benchmark of 10%.

4. The bottom line
Net margin tells us how much profit a company makes from every dollar of sales. P&G's net margin is a rule-making 12%, beating our benchmark of 10%.

5. To the poorhouse, and step on it
Not quite. Rule makers should be cash-heavy and debt-light, ideally having 1.5 times more cash than debt. A look at the balance sheet tells us P&G has $32 billion in debt and $2.8 billion in cash, the extreme opposite of what we're looking for.

But a stable of brands as vast as P&G's doesn't come cheap, and this debt fueled those acquisitions. Money is cheap right now, and P&G is such a reliable profit generator that it can pay down the debt at will. P&G gets a well-deserved pass on this rule.

6. Cash rules, Fools
The Foolish flow ratio measures how well a company manages its inventory and cash. To calculate it, take current assets minus cash and divide by current liabilities. P&G comes in at an outstanding 0.70, telling us the company is keeping its inventory and accounts receivables low and paying suppliers on its own terms. The best companies have Foolish flow ratios under 1.0.

7. What's in a name? 
A lot. Your familiarity and interest in a company helps you understand exactly what it does and how it makes money, thereby lowering your overall risk. For me, P&G and its array of instantly recognizable and understandable brands score as highly as possible in this regard.

Pretender to the throne, or king?
Mass-market appeal. Strong pricing power. An exceptional bottom line. A gorgeous Foolish flow ratio, and an easily understandable business model.

Where does all this leave us? There's no doubt P&G is a powerhouse, but is it a rule maker? Stay tuned for Part 2 of this article, where we torture the numbers even more and find out what makes a rule maker a rule maker, and whether you should put your money where your Crest is.

At the time this article was published Gillette razors leave Fool contributorJohn Grgurich's face feeling smooth and silky, but he owns no shares of any of the companies mentioned in this article. The Motley Fool owns shares of Clorox.Motley Fool newsletter serviceshave recommended buying shares of Procter & Gamble and Clorox. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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