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 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 electronics-payment processor Visa (NYSE: V ) through Tom Gardner's merciless gauntlet and see whether it has what it takes to make the rule-maker grade.
1. The mass-market, repeat purchase of low-priced goods
It's no great insight that the world of purchasing is becoming more and more of an electronic one. I hardly ever carry cash anymore, and am very rarely caught out because of it.
One of the companies that makes this possible is Visa, which runs the network connecting your banks to your merchants. Visa makes a percentage of each credit or debit card sale it processes. The company is so widely accepted by merchants -- that's a lot of sales. As such, Visa easily makes our first rule-maker grade.
Compare this with peer American Express (NYSE: AXP ) . AmEx also gets a percentage of each of the sales it processes, but because merchants typically pay a higher rate for purchases made with an AmEx card than those made with a Visa or MasterCard (NYSE: MA ) , they are less likely to accept AmEx. This means fewer overall sales for AmEx and a lower ranking from a rule-maker standpoint.
2. Gross margin
Gross margin indicates pricing power and manufacturing efficiency. The ideal gross margin for a rule maker is 60%. At 84.3% trailing 12 months, Visa crushes this metric. At 76% TTM, AmEx is also very strong, but in the top lines of the income statement Visa does a better job controlling costs.
3. Net profit margin
Net profit margin dictates how many pennies a company gets to keep from every dollar of sales. Visa comes in at a big 40%. MasterCard, at 28.4%, is also very strong, but Visa is keeping more than $0.10 extra per every dollar of sales. That adds up quickly when you're talking about the volume of sales these two companies process. American Express clocks in at 17.1%, still a good percentage in an absolute sense, but not nearly as good as either Visa or MasterCard.
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. At 13.8% year over year, Visa easily makes the rule-maker grade. American Express grew its revenue by 4.7% -- solid, but not rule-maker solid. MasterCard grew its revenue by a big 20.2%, by far the best of the bunch.
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. The balance sheet shows Visa has $2.74 billion in cash and no long-term debt. Perfect. Discover Financial Services (NYSE: DFS ) has $2.85 billion in cash and $14.96 billion in long-term debt on its books, for a cash-to-debt ratio of 0.19. On this depressing metric, the only consolation for Discover is that money is cheap right now, so the company isn't getting crushed by high interest payments.
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. Visa's is a beautiful 0.81, AmEx comes in at a slightly more beautiful 0.77, and MasterCard at an even prettier 0.51. But Visa's 0.81 is as good as a rule maker needs to be.
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 overall investing risk.
"Visa. It's everywhere you want to be." Courtesy of some great ad campaigns and the fact that you see the company name every time you pull out your credit card, Visa has great name recognition. Compare this with Discover. Sure, the upstart payment-services company made quick inroads into what has long been a three-way game between Visa, MasterCard, and AmEx, but Discover doesn't have nearly the same worldwide recognition as the other three -- and it's still not accepted as widely. Discover, therefore, scores significantly lower on this rule-maker metric.
Three cheers for rule-maker Visa
Visa easily meets or surpasses all of our benchmarks, making it the king of its market space and an undisputed rule-maker investment. But companies and the markets are constantly in motion, so please remember to check in with your rule-maker investments every quarter.
Of course, Visa isn't the only stock you can profitably and confidently hold onto 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 it's hot by clicking here now.