When I began investing, I was starting from a knowledge base of zero. Nada. Absolute scratch.
One of the first books I read when I was starting out 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 the world-renowned Apple (NAS: AAPL) through Tom Gardner's merciless gauntlet and see exactly what it takes to make the Rule-Maker grade. In the course of our analysis, we'll use quarterly earnings numbers for the period ended July 25 of this year.
1. The mass-market, repeated purchase of low-priced goods
It's only a matter of time before your iPad, iPhone, or MacBook succumbs to the ravages of technological obsolescence and needs to be replaced. Then, like dutiful Apple groupies, most head right out and buy a new one. No questions asked.
Electronic devices are the perfect example of mass-market items with a limited lifespan that will need to be replaced over and over. You can argue that Apple products aren't exactly low-priced, especially compared with an equivalent Dell (NAS: DELL) or Hewlett-Packard (NYS: HPQ) product, but they're not cars or diamond rings, either. Apple easily makes the Rule-Maker grade here.
2. Gross margin
Gross margin indicates pricing power and manufacturing efficiencies. Per Tom Gardner, the ideal gross margin for a Rule Maker is 60%, but the economics of the computer and personal-technology sector make that an unrealistic target.
Apple's gross margin for the most recent quarter was 42%, which is phenomenal, and a sign of the company's unusual brand and pricing power in its space. In comparison, HP's gross margin is 24%. Dell's is only 23% for the same period. Apple, in effect, passes the Rule-Maker test here.
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 money a company gets to keep from every dollar of sales.
Apple's net profit margin for the LTM is 24%, crushing the Rule-Maker minimum of 10%. Again, in a heavily commoditized industry, Apple charges more and keeps more, because it can. BlackBerry maker Research In Motion's (NAS: RIMM) net profit margin for the same period is an enviable 14.3%, except in comparison with Apple's.
4. Sales growth
Year-over-year sales growth counts even for big companies, where it will naturally slow with age, because it's an indicator of business momentum. Top-tier Rule Makers grow their sales by 10% every year.
Get ready. In yet another display of Apple's market-dominating position, sales skyrocketed by 82%. Chalk this up to sales increases of 142% for the iPhone and 183% for the iPad. Just staggering numbers here.
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 asset side of the balance sheet shows us Apple has $28.4 billion in cash, cash equivalents, and short-term investments. On the other side it has ... zero long-term debt. Truly remarkable. Well done, Apple.
Were it not up against freakishly successful Apple, peer Nokia (NYS: NOK) has what would be an enviable balance sheet, with $16.5 billion in cash, cash equivalents, and short-term investments, and no long-term debt.
6. The Foolish Flow Ratio
The Foolish Flow Ratio measures how well a company manages its inventory and cash. Specifically, a company should be keeping its inventory and accounts receivables low, and paying suppliers on its own terms -- both strong indicators of market-space dominance.
To calculate the Foolish flow ratio, take current assets minus cash and short-term investments and divide by current liabilities. Apple comes in at 0.69. The best companies have Foolish flow ratios of 1.0 or less. Bravo.
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 investing risk.
The Gospel of Jobs has been spread far and wide throughout this world, and the company's business model is simple enough for anyone to understand. Apple is tops in brand recognition on many rankings, brushing shoulders with longtime known-the-world-over brands like Coca-Cola (NYS: KO) and McDonald's (NYS: MCD) .
The Rule Maker of all Rule Makers
I've been through this Rule-Maker exercise a number of times, and no other company has even come close to Apple's metric-crushing numbers. It's an incredible company. Still, all companies need the occasional check-in, even beloved Apple. So the metrics used here should be applied to all of your Rule Maker investments each quarter, at earnings time.
In Rule Breakers, Rule Makers, Tom Gardner goes into even greater depth and detail about what exactly makes a Rule Maker a Rule Maker. So I suggest you pick up a copy for yourself and get the whole story from the man who literally wrote the book on it.
Apple 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 they think will maintain their edge and outperform over the long term. Get a free copy of their special report.
At the time thisarticle was published Fool contributorJohn Grgurichexpresses his sincere condolences to Steve Jobs' family, friends, and all the people at Apple. John owns no shares of any of the companies mentioned in this article. The Motley Fool owns shares of Coca-Cola and Apple.Motley Fool newsletter serviceshave recommended buying shares of Apple, McDonald's, Dell, and Coca-Cola and creating a bull call spread position in Apple. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't 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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