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 McDonald's (NYSE: MCD ) through Tom's merciless gauntlet to see if the classic American burger joint has what it takes to make the rule-maker grade.
1. The mass-market, repeat purchase of low-priced goods
Burger, fries, drink. Repeat endlessly. People need to eat, and if you can make a product they really like at a price they can afford, you're in the money. This is exactly what McDonald's has done in the U.S. and around the world since 1940. How many billions have been served? McDonald's practically defines this rule-maker category.
2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a rule maker is 60%. Not all economic sectors are created equal, however, and to be realistic we have to take these differences into account, even for rule makers. As such, McDonald's gross margin is 39.59% trailing 12 months, but is well above the industry average of 30.37% TTM.
Rival Yum! Brands (NYSE: YUM ) , which owns and operates Taco Bell and KFC, only manages 26.65% TTM on this important metric. Boutique burrito-maker Chipotle Mexican Grill (NYSE: CMG ) does better but still trails McDonalds at 37.33% TTM. Finally, boutique-coffee maker and fine-food retailer Starbucks (Nasdaq: SBUX ) comes in at an enviable 56.38% TTM, but at 39.59% McDonald's is doing all it needs to do here.
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. At 20.26% TTM, McDonald's crushes this metric. Yum! comes in at a robust 11.69% TTM, Chipotle at a healthy 9.63% TTM, and Starbucks at an even healthier 10.56% TTM. Well done to all our companies here.
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.
At 7.1% year over year, McDonald's could be doing slightly better, but growth is still healthy, especially for a more than 70-year-old company. In comparison, young bucks Yum!, Chipotle, and Starbucks grew their revenues at an enviable 13.1% YOY, an astounding 25.8% YOY, and a big 14.7% YOY, respectively.
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.
- With $2.35 billion in cash and $12.51 billion in debt, McDonald's has an unenviable cash-to-debt ratio of 0.19.
- Yum! has $1.1 billion in cash and $3.3 billion in debt, for a slightly more enviable C/D of 0.33.
- Chipotle has $465 million in cash and $3.63 million in debt, for a killer C/D of 128.1.
- Starbucks has $2.27 billion in cash and $549.5 million in debt, for a great C/D of 4.13.
Kudos to Starbucks and Chipotle on this metric. For Yum! and McDonald's, the only consolation for any of them, and for investors, is that right now money is cheap.
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.
On this metric, McDonald's comes in at a very healthy 0.58, Yum! at an even slightly more healthy 0.5, Chipotle at a happy 0.7, and Starbucks at a lean 0.91. All four of our companies are staying lean and mean on this important metric.
7. Your familiarity and interest
What's in a name? A lot. 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.
McDonald's prepares and sells food and beverages to the public. Dead simple. You know exactly how a company like this makes its money after one visit, and that's the kind of company we like all of our rule-maker investments to be.
Three cheers for rule-maker McDonald's
We'd like it better if McDonald's had a little more cash and a little less debt, and we'd like revenue growth to be a bit more robust, but regardless, the company falls well within our rule-maker range of requirements. Remember: Rule makers -- as older, more established companies -- don't have to hit every number out of the park. Their beauty lies in their longevity, and their ability to steadily generate revenue and profit quarter after quarter, year after year.
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.
Of course, McDonald's isn't the only easy-to-understand 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 the stock is hot by clicking here now.