When I began investing, I was starting from a knowledge base of zero.
One of the first books I read was The Motley Fool's Rule Breakers, Rule Makers. In it, Motley Fool co-founder 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 on to 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 consumer-electronic giant Apple (NAS: AAPL) through Tom's merciless gauntlet and see if it has what it takes to make the Rule Maker grade.
1.The mass-market, repeat purchase of low-priced goods
Apple practically defines this category, with a growing list of must-have electronic gadgets the world can't seem to get enough of, including iPods, iPhones, and iPads. The only thing you can argue with regarding the stated benchmark is that Apple products are not "low priced," at least not in comparison to competitors' products.
For instance, you can get a Dell laptop or desktop machine for much less than a comparable Apple one. And Google Android phones can go out the door for much less than an iPhone. Regardless, overall Apple easily makes our first Rule Maker grade.
Gross margin indicates pricing power and manufacturing efficiency -- both of which have an undeniable impact on the bottom line. The ideal gross margin for a Rule Maker is 60%. As such, Apple's 42.41% trailing 12 months may look weak, but Dell's is a mere 22.33% and Hewlett-Packard's (NYS: HPQ) is only 23.24%, not much better than Dell's.
So while Apple's gross margin isn't 60%, it's still top of its class. At 65.21%, Google's gross margin is very strong, but since the company doesn't actually manufacture physical items a la Apple, it's not an ideal comparison for this metric.
Net-profit margin dictates how many pennies a company gets to keep from every dollar of sales. Apple's net profit margin is a whopping 25.8%. At 25.69%, Google is essentially dead even with Apple.
Dell's net-profit margin, however, is a meager 5.63%, and HP's an even more meager 4.75%. There's a reason Apple currently has close to $100 billion in the bank, and there's a reason Dell and HP don't. Those 20-some extra pennies per dollar add up. Google's $43.33 billion in the bank attests to that, as well.
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. At 73.3% year over year, Apple massacres the Rule Maker benchmark. Dell grew its YOY revenue by 2.2%, while HP shrank its YOY revenue by 7%. Even the mighty Google, at 25.4% YOY revenue growth, couldn't beat Apple.
Rule Makers should be cash heavy and debt light, ideally having at least 1.5 times more cash than debt. As previously mentioned, Apple has nearly $100 billion in the bank; the company also has zero debt, making for the perfect cash-to-debt ratio. Dell has $14.82 billion on hand, and $9.25 billion in debt, for a C/D ratio of 1.6, which isn't bad.
HP has $8.12 billion in cash and $30.96 billion in debt, giving it a C/D ratio of only 0.26, which is bad. Google, somewhat surprisingly, actually has some debt: $6.21 billion, to be precise, but $43.3 billion in cash gives it a happy C/D ratio of 6.97.
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 its accounts payables high -- strong indicators of market-space dominance.
To calculate the Foolish Flow Ratio, take current assets minus cash, cash equivalents, and short-term investments and divide by current liabilities. The best companies have Foolish Flow Ratios of 1.0 or less. Apple's is 0.71. Dell's is an even better 0.66. HP and Google both do well on this metric, coming in at 0.91.
7. Your familiarity and interest
What's in a name? A lot. Your familiarity with and interest in a company help you understand exactly what it does and how it makes money, thereby lowering your overall investing risk.
As we said earlier, Apple makes and sells arguably the hottest consumer-electronic devices on the planet, so there's no mystery as to how it makes money. And the brand is easily one of the most recognized in the world. Apple easily maxes out this metric, then.
Three cheers for Rule Maker Apple
Apple meets or crushes all of our benchmarks, making it the king of its market space and an undisputed Rule Maker investment. But companies and markets are constantly in motion, so please remember to check in with your Rule Maker investments every quarter, even with a company so seemingly dominant as Apple.
Of course, Apple isn't the only easy-to-understand stock you can profitably and confidently hold on to for the long term. Learn about the stock The Motley Fool is calling its top pick for 2012 in this special free report: "The Motley Fool's Top Stock for 2012." Get it while the stock is hot by clicking here now.
At the time thisarticle was published Fool contributorJohn Grgurichhas massacred many metrics himself, but owns no shares of any of the companies mentioned in this column. Follow John's dispatches from the bloody front lines of capitalism on Twitter@TMFGrgurich. The Motley Fool owns shares of Google and Apple. Motley Fool newsletter services have recommended buying shares of Apple and Google. Motley Fool newsletter services have recommended creating a bull call spread position in Apple and writing covered calls on Dell. The Motley Fool has a scintillating disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
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