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 started 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 athletic-gear giant Nike (NYSE: NKE ) 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 Aug. 31 of this year.
1. The mass-market, repeated purchase of low-priced goods
After enough joint-grinding marathons, concussion-inducing football games, or even gentle sashays through the park, your athletic shoes are going to wear out. Then, like a dutiful Nike-brand loyalist, many go right out and buy a new pair. No questions asked.
Athletic shoes are perfect examples of mass-market items with a limited lifespan that will need to be replaced over and over. Nike 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%. Nike's is 44.3%. Peer Under Armour's (NYSE: UA ) is 46%. lululemon athletica's (Nasdaq: LULU ) is a significantly higher 57.5%.
To be fair to Nike, lululemon is benefitting from an ongoing trend that's seeing investor and consumer money flooding unevenly to the luxury brands, at the expense of more middle-tier companies like Nike (see my column on the subject). So sure, we'd like Nike to be doing better here, but a gross margin of 44.3% is comfortably in the rule-maker range.
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. Nike's is 10.6%, nicely topping the rule-maker minimum of 10%. Well done.
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.
In a healthy display of Nike's market-dominating position, sales growth over this quarter last year was a very strong 17.5%. And though that still falls short of footwear competitor Crocs (Nasdaq: CROX ) 23% growth, we won't hold it against Nike. Well done, Nike.
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 Nike has $3.7 billion in cash, cash equivalents, and short-term investments. On the liabilities side it has $238 million in long-term debt. This gives Nike a cash-to-debt ratio of 15.5. Bravo.
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, but 1.25 is acceptable as the upper end. Nike comes in at 1.95: not catastrophic by any means, but not desirable. We'll want to keep an eye on this number over successive quarters.
7. Your familiarity and interest
What's in a name, you ask? A lot. Your familiarity and interest help you understand exactly what a company does and how it makes money, thereby lowering your investing risk.
Name and brand recognition for Nike is as good as it gets. The Gospel of the Swoosh has been spread far and wide, and the business model is simple enough for anyone to understand.
A runner's, and Foolish investor's, dream
Great top and bottom lines. Lots of cash, very little debt, and a healthy gross margin. Great brand recognition in mass-market, easily understandable business. A Foolish Flow Ratio we'll need to keep an eye on, which is why the metrics used here should be applied to all of your Rule Maker investments each quarter.
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.
Nike 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. You can get a free copy of their special report.