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 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 software giant Microsoft (Nasdaq: MSFT ) 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 ending Sept. 30, 2011.
1. The mass-market, repeated purchase of low-priced goods
Just the other day, I had to buy a new laptop. It came loaded with everything except what I needed most -- Microsoft Office. So I bought a copy for $200. After more than 20 years of using word processing and spreadsheet software, I'm still using Microsoft Office, and I've never used anything else. Why?
Well, what else is there? Whether you're a student, a professional, or a mom tracking the family budget, Microsoft is your only real option. Plus, chances are, you're reading this right now on a machine running the Microsoft Windows operating system. And in four or five years, you'll have to replace everything.
Computer software is the perfect example of a mass-market item with a limited lifespan that will need to be replaced over and over. Microsoft 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%; Microsoft's is a staggering 78%. Oracle, a direct competitor in the relationship-database software arena, actually comes in very close to Microsoft with a gross margin of 77.8%.
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 tells us how much money a company gets to keep from every dollar of sales. Microsoft's is a whopping 33%. Google isn't a perfect apples-to-apples peer with Microsoft (no one really is), but even its net profit margin is only 28%.
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.
Apple grew its revenue by a staggering 39% year over year, but Apple is the superman of tech companies. Microsoft grew its revenue by 7.3% year over year. Respectable, but not exactly where we'd like to see it.
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 Microsoft has $57.4 billion in cash, cash equivalents, and short-term investments. On the liabilities side it has a little more than $11.9 billion in long-term debt. This gives Microsoft a cash-to-debt ratio of 4.8. 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. 1.25 is acceptable as the upper end. Microsoft's is a beautiful 0.7. Nicely done.
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.
As was mentioned already, just about anyone who does anything on a computer anywhere on the planet has heard of, and paid money to, Microsoft. Brand recognition is probably up there with Coca-Cola, the world's greatest brand, and a Rule Maker in its own space.
Let's hear it for Rule Maker Microsoft
A beautiful bottom line. Loads of cash and very little debt. A killer gross margin. Strong brand recognition in a mass-market, repeat business. An enviable Foolish Flow Ratio. Microsoft is a Rule Maker of the highest order. There's nothing not to like about the company, but remember that 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. 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.
Of course, Microsoft isn't the only 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, aptly titled "The Motley Fool's Top Stock for 2012." Get it while it's hot by clicking here now.