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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," 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 adult-beverage giant Diageo (NYSE: DEO ) through Tom'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
You may not know the name Diageo, but if you drink alcohol of just about any variety, you know the company's brands. Diageo is home to Johnnie Walker, Tanqueray, Smirnoff, Guinness, Harp, Sterling Vineyards, and more.
Diageo owns nearly one-fifth of the world's top 100 liquor brands and sells its products in more than 180 countries. As such, Diageo easily makes our first Rule Maker benchmark.
2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%. Diageo's trailing-12-month gross margin hits it on the nose at 60%. Beer giant Molson Coors Brewing's (NYSE: TAP ) TTM gross margin is a not-so-killer 41.8%. Anheuser-Busch InBev (NYSE: BUD ) , with a TTM gross margin of 57%, is doing almost as good a job as Diageo at keeping its top lines in check.
Let's have a quick look at their non-alcoholic cousins. Coca-Cola (NYSE: KO ) matches Diageo on this important metric, with a TTM gross margin of exactly 60%, while PepsiCo (NYSE: PEP ) comes in fourth overall with a TTM gross margin of 52.1%. PepsiCo also has its snacks division, which by nature will drag its number lower.
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 15.99% TTM, Diageo easily beats our benchmark. Molson Coors, at 19.13% TTM, does even better. Anheuser-Busch is strong on net-profit, too, coming in at 16.71% TTM. And finally, over to Coke and Pepsi, we see a big 18.5% and healthy 9.59%, respectively.
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.
Diageo comes close with a respectable 8.2% year-over-year growth in sales. Molson-Coors does not, with YOY revenue growth of 0.10%. At 3.7%, Anheuser-Busch is holding its own, just barely, on this metric. At 5.9%, Coke does slightly better, while Pepsi joins the middling crowd with YOY sales growth of 4.1%.
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.
- $1.74 billion of cash and $14.9 billion in debt give Diageo the unenviable C/D ratio of 0.11.
- $836 million in cash and $2 billion in debt give Molson Coors a slight advantage, with a C/D ratio of 0.41.
- $5.42 billion in cash and $40.16 billion in debt give Anheuser-Busch almost as poor a C/D ratio as Diageo, at 0.13.
- $15.78 billion in cash and $31.12 billion in debt give the mighty Coca-Cola a not-so-mighty C/D ratio of 0.50.
- Finally, $3.81 billion and $27.71 billion in debt put Pepsi dead even with Anheuser-Busch, at a C/D ratio f 0.13.
None of our companies even comes close to hitting our benchmark. With interest rates as low as they are, the only good thing you can say about this situation is that the debt is cheap, and that's still not saying much.
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 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 divide by current liabilities. The acceptable upper limit for the Foolish flow ratio is 1.25, but the lower the number, the better:
- Diageo comes in at a healthy 1.13.
- Molson Coors comes in at an even healthier 0.97.
- At 0.35, Anheuser-Busch positively smokes this metric.
- Coke comes in strong at 0.49.
- Pepsi does excellent here, too, with 0.81.
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.
Diageo makes and sells alcoholic beverages, with some of the best-known brands on the planet in its stable. That's a dead simple business model, and is exactly what we like to see in a Rule Maker.
Three cheers for Rule Maker Diageo
We'd like it better if Diageo had a better cash-to-debt ratio, and a bit better YOY revenue growth, but otherwise the company is doing everything it needs to do as a Rule Maker. 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.
McDonald's is another example of an 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.