This Stock Is a Rule Maker

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When I began investing, I was starting from a knowledge base of zero. Nada. Absolute scratch.

One of the first books I read was The Motley Fool's Rule Breakers, Rule Makers. In it, Motley Fool co-founder and CEO Tom Gardner laid out specific criteria for crowning a company a "rule maker," i.e., a large, mature, consumer-facing company that's king of its market space, and an investment that can be confidently and profitably held onto for years with only quarterly check-ins. 

His step-by-step process for analyzing a business was an easily understandable way for a beginner like me to quickly get up to speed, but its back-to-basics methodology will benefit even advanced investors.

Today we're going to run beverage giant Coca-Cola (NYS: KO) through Tom's Gardner's merciless gauntlet and see what it takes to make the rule-maker grade. In the course of our analysis, we'll use quarterly earnings numbers for the period ending July 1 of this year.

1.The mass-market, repeated purchase of low-priced goods
This one is a no-brainer. Coca-Cola averages 1.7 billion servings of its beverages every day. Coca-Cola practically defines this category.

2.Gross margin
The gross margin for a rule maker should be 60% or over, indicating market-dominating pricing power and manufacturing efficiencies. Coca-Cola's is a solid 61%. In comparison, peer PepsiCo's (NYS: PEP) gross margin is 52.7%. Good, but not rule-maker good.

3.Net profit margin
As Tom Gardner so aptly puts it in the book, "The reward of high gross margin is surpassed only by the treasures of high net profit margin." Net profit margin, as a reminder, tells us how much profit a company makes from every dollar of sales. Coca-Cola's is 36%, blowing away our rule-maker minimum of 10%.

4.Sales growth
A year-over-year growth in sales counts even for big companies, where it will naturally slow with age, because it's an indicator of business momentum.

Coca-Cola's sales growth is a staggering 47%. Now, keep in mind this is due primarily to the company acquiring the North American operations of bottling giant Coca-Cola Enterprises at the end of 2010 (and revenues for both companies were combined), but there was also significant growth in China and Russia.

Our rule-maker minimum for this metric was 10%, which Coke obliterated. In comparison, Dr Pepper Snapple Group's (NYS: DPS) sales growth is a considerably lower 4.1%.

5.Cash-to-debt ratio
Rule makers should be cash heavy and debt light, ideally having at least 1.5 times more cash than debt. A look at the balance sheet shows us Coca-Cola has $10.2 billion in cash and $11.4 billion in debt. Ouch. Not exactly what we're looking for, right?

Well, you can see that the jump in debt came at the end of 2010, when the company acquired Coca-Cola Enterprises. Debt is never a great thing, but sometimes it's a necessary thing. And for a steady, profit-generating machine like Coca-Cola, it's fine. The company can pay it down at will. And money is cheap right now. So we won't ding them for this from a rule-maker perspective.

Consider Procter & Gamble (NYS: PG) , a rule maker in its own space, has $22 billion in debt on its books. Again, it's the cost of acquisitions, but the business is stronger as a result.

6.The Foolish flow ratio
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.

Coca-Cola comes in at 0.68, telling us the company is keeping its inventory and accounts receivable low, and paying suppliers on its own terms, both strong indicators of market-space dominance. The best companies have Foolish flow ratios of 1.0 or less. Well done, Coke.

7.Your familiarity and interest
What's in a name, you ask? A lot. Your familiarity and interest in a company help you understand exactly what the business does and how it makes money, thereby lowering your overall risk. For me, Coca-Cola, with its iconic brand and simple business model, gets top marks.

Coke is the real thing ... and the king of its market space
Mass-market appeal. Solid pricing power. Exceptional top and bottom lines. A great Foolish flow ratio and an easily understandable business model. Coca-Cola is a true rule maker in its space. As a reminder, the metrics we used here should be applied to all of your rule-maker investments each quarter at earnings time.

In The Motley Fool's Rule Breakers, Rule Makers, Tom Gardner goes into even greater depth about exactly what makes a rule maker a rule maker. I suggest you pick up a copy for yourself and get the whole story from the man who, literally, wrote the book on it.

Coca-Cola isn't the only stock you can profitably and confidently hold onto for the long term. My fellow Fools have picked out -- and bought shares of -- five more companies that they think will maintain their edge and outperform over the long term. You can get a free copy of their special report by clicking here.

At the time this article was published Fool contributor John Grgurich attributes his semi-svelte physique to Diet Coke and chasing his 3-year-old boy around the house, but he owns no shares of Coca-Cola or any of the other companies mentioned in this article. The Motley Fool owns shares of Coca-Cola and PepsiCo. Motley Fool newsletter services have recommended buying shares of PepsiCo, Coca-Cola, and Procter & Gamble. Motley Fool newsletter services have recommended creating a diagonal call position in PepsiCo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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