Why Google Is a Classic Rule Maker, and Why It Should Be in Every Investor's Portfolio

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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": a mature, consumer-facing business that's king of its market space, and an investment that can confidently and profitably be 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 approach will benefit even advanced investors. Today we're going to run search giant Google (Nasdaq: GOOG  ) through Tom's merciless gauntlet and see exactly what makes it a classic Rule-Maker.

1. The mass-market, repeat purchase of low-priced goods
Google doesn't sell anything. Well, not to you, anyway. Google sells advertising space to companies, and the hope is when you "Google" something, you'll click on an accompanying ad and keep those advertisers coming back for more. This isn't the easiest business model to get one's head around, but given how often the typical Web surfer Googles things, it's apparent how mass-market the whole operation is. As such, Google is solid on this Rule Maker benchmark, if not exceptional.

2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%.

  • With a gross margin of 60% for the trailing 12 months, Google nails our first Rule-Maker benchmark.
  • Rival search-provider Yahoo! (Nasdaq: YHOO  ) pulls off an impressive 69% gross margin.
  • Internet stalwart AOL (NYSE: AOL  ) manages a mere 28% on this metric.
  • Finally, newcomer Facebook (Nasdaq: FB  ) has the best gross margin of all: 74%. Way to go, Mr. Zuckerberg.

3. Net-profit margin
Net-profit margin dictates how many pennies a company gets to keep from every dollar of sales. Tom Gardner likes to see net-profit margins of 10% for his Rule Makers.

  • Google's net-profit margin TTM is a whopping 22.2%.
  • Facebook's net-profit margin TTM is a solid if not quite whopping 6.28%.

(Note: Net-profit margins for Yahoo! and AOL as reported by two trusted services seemed strangely off. As such, I've omitted those two companies from this analysis on this metric. The upshot is, though, that Google more than maxed this metric out.)

4. Sales growth
Year-over-year sales, or revenue, 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.

  • Google grew its revenue by a staggering 45.1% YOY.
  • Yahoo!'s revenue contracted by 1.2% YOY.
  • AOL's revenue also contracted, by 2% YOY.
  • Facebook grew its revenue by a big 32.3% YOY.

5. Cash-to-debt ratio
Rule Makers should be cash heavy and debt light, ideally having at least 1.5 times as much cash as debt:

  • $45.7 billion in cash and $7.9 billion in debt give Google the beautiful C/D of 5.78.
  • $8.4 billion in cash and $125.5 million debt give Yahoo! the even more beautiful C/D of 66.9.
  • $1.5 billion in cash and $108.4 million in debt give AOL another great C/D: 13.8.
  • Finally, $10.5 billion in cash and $902 million in debt give Facebook still another great C/D: 11.6.

Money is so cheap right now. A little too cheap. As such, too many companies are in debt up to their corner offices. Kudos to all four of these organizations for keeping their coffers full and their debt low.

6. The Foolish Flow Ratio
The Foolish Flow Ratio measures how well a company manages its inventory and cash. A company should be keeping its inventory and accounts receivable low and its accounts payable 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 then divide by current liabilities. The acceptable upper limit for the Foolish flow ratio is 1.25, but the lower the number, the better:

  • Google hits a lovely low F/F of 0.77.
  • Yahoo! just misses our benchmark, with an F/F of 1.26.
  • AOL comes in with a very nice F/F of 0.79.
  • Finally, Facebook comes in on the high side, with an F/F of 1.70.

7. Your familiarity and interest
What's in a name? Quite a bit. Your familiarity and interest with a company help you understand exactly what it does and how it makes money, thereby lowering your overall investing risk.

Google is one of the best-known corporate brands on the planet. It's such a part of our day-to-day existence it even made the leap from proper noun to verb. But it still has a bit of a convoluted business model, unlike, say, Coca-Cola, which very simply sells people soda. Google, then, while solid on this metric, isn't top of the pops.

Google it
The only metrics we can ding Google on a bit are the more subjective ones, No. 1 and No. 7. Google isn't the simplest company to get one's head around, but a little bit of thinking (always a good thing) leaves one comfortable enough on these two metrics, and the search giant's commanding performance on the remainder make it a no-brainer Rule Maker.

But always remember to check in on your Rule-Maker investments once a quarter by running them through this simple checklist. 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 wrote the book on it.

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John Grgurich has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Facebook, Google, and Yahoo! and has options on Facebook. Motley Fool newsletter services recommend Apple, Facebook, Google, and Yahoo!. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 01, 2013, at 10:51 AM, FreeNachos wrote:

    I don't follow the "Foolish Flow" ratio calculation for Google. I've been doing it and redoing it - based on the numbers available when this was written - I get 52.7B in current assets, minus 9.9B (cash), then divide that number by 8.9B (current liabilities) and I get 4.8.

    You, and the rest of the internet get a MUCH lower number...soooo, what am I missing!?

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