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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:" a big, 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 approach will benefit even advanced investors. Today, we're going to run coffee-shop hipster Starbucks (NYSE: SBUX ) through Tom's merciless gauntlet and see if it has what it takes to make the Rule-Maker grade.
1. The mass-market, repeat purchase of low-priced goods
Latte, scone, pound of beans. Repeat, seemingly endlessly. Starbucks has practically become the new McDonald's (NYSE: MCD ) : the go-to place for everyone from tweens and teens, to suits and ties, to the hip and not-so-hip. If Starbucks had a bit of a too-cool-for-school image problem in the beginning, it doesn't anymore.
Starbucks is everywhere you want them to be, and maybe a few places you don't. As such, the company easily makes our first Rule-Maker grade.
2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%.
- With a gross margin of 56% trailing 12months, Starbucks just misses our ideal, but is hardly a slacker.
- McDonald's, a company that's been doing this sort of thing (serving food and beverages) long enough, ought to have a better gross margin than it does: 40% TTM.
- Dunkin is king of this metric, with a gross margin of 81% TTM. Go, Dunkin.
- Yum! Brands (NYSE: YUM ) , another food and beverage maven, is the worst of the bunch, with a gross margin of just 26% TTM.
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.
- Our hero-in-waiting, Starbucks, hits a nice 10.7% net-profit margin TTM.
- McDonald's knocks the Big Mac out of the park here, with a net-profit margin of 20% TTM.
- Dunkin does well here, too, coming in just shy of our benchmark, at 9.7% TTM.
- Yum! does better than most of our contenders, coming in just over our benchmark at 11.49%.
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.
- Starbucks comes in strong on this metric, with 15% YOY revenue growth.
- McDonald's is solid, but shy of our ideal, at 7% YOY growth.
- Dunkin hits its mark, at 10% YOY growth.
- Yum! does very well here, with 13% YOY revenue growth.
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:
- $2.5 billion in cash and $550 billion in debt give Starbucks the enviable C/D of 4.54.
- $2.5 billion in cash and $13.57 billion in debt give McDonald's the unenviable C/D of 0.18.
- $219 million in cash and $1.47 billion in debt give Dunkin the even more unenviable C/D of 0.15.
- Finally, $989 million in cash and $3.31 billion in debt give Yum! a slightly better -- but still terrible -- C/D of 0.30.
With money as cheap as it is, too many companies today are loaded up on debt, and it's not healthy. When a company gets into a tight spot, which is inevitable, there's nothing like having cash in the bank to see it through. Kudos, then, on this metric, Starbucks.
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, then divide by current liabilities. The acceptable upper limit for the Foolish flow ratio is 1.25, but the lower the number the better:
- At 1.03, Starbucks is solid on its F/F ratio.
- McDonald's has a very low F/F: 0.56.
- Dunkin is running a tight ship, as well, with an F/F of 0.44.
- Yum!, at 0.49, is no slacker here either.
7. Your familiarity and interest
What's in a name? Quite a bit. 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.
Starbucks sells coffee, tea, treats, the odd sandwich, and newspapers, and gives you a great place to sit around and enjoy them all until they shut out the lights and go home, at which point the company is required by law to kick you out. This is a beautifully simple business model, and everyone knows Starbucks. Highest marks on this metric.
King of the world, ma
Starbucks easily hits all its marks here, and is no doubt a Rule Maker in the finest sense of the phrase. Does it hit each and every metric out of the park? No, but it doesn't need to.
As older, more established companies, Rule Makers' beauty lie primarily in their longevity: their ability to steadily generate revenue and profit quarter after quarter, year after year. There will be inevitable ups and downs, good quarters and bad, but the Rule Maker is the company that is strong on all Tom Gardner's metrics, without necessarily being the best at any one or two.
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 wrote the book on it.
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