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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 online-auction giant eBay (NYSE: EBAY ) 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
To the best of my recollection, eBay's birth in 1995 was initially greeted with barely disguised smirks and sneers: What is this, some kind of online flea market?
Well, those smirks and sneers have since been authoritatively wiped off of offending faces. eBay is ubiquitous in almost all our lives now, selling nearly everything you can think of -- used and new, pricey and cheap -- in remarkable volumes. As such, eBay 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 71% over the trailing twelve months, eBay blows this metric away like I've rarely seen.
- Rival online catch-all Google (Nasdaq: GOOG ) also does exceptionally well here, coming it at 63% TTM.
- Amazon.com (Nasdaq: AMZN ) ? Not so much, with a lackluster 23% TTM.
- The lord of overstock, Overstock.com (Nasdaq: OSTK ) , pulls in dead last in this race, with a gross margin of only 17% 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, eBay, pulls off an incredible 28% net-profit margin over the trailing 12 months.
- Google, not to be outdone, comes in at a near-equally incredible 27% on this metric.
- Amazon is crushed here, with a net-profit margin of only 0.69% TTM (the company continues to sell product in amazing volumes with razor-thin margins to capture market share).
- Overstock.com again pulls up last, with a net-profit margin of -0.76% TTM.
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.
- eBay again blows past our benchmark here, with year-over-year quarterly sales growth of 23%.
- Google does eBay 12% better, with YOY growth of 35%.
- Amazon finally shows up to the race, posting YOY growth of 30% (again, capturing market share, even if profits are essentially nil).
- Speaking of essentially nil, Overstock's YOY sales grew an essentially a flat 0.02%.
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:
- $5.75 billion in cash and $2.08 billion in debt gives eBay the enviable cash/debt ratio of 2.76.
- But even the mighty eBay is no match for Google: $41.72 billion in cash, and $8.12 billion in debt gives it the even more enviable C/D of 5.13.
- Surprise, surprise though: Amazon has the best C/D position of all, with $4.97 billion in cash on hand and zero debt. Well done, Amazon.
- Finally, $60 million in cash and $17 million in debt gives Overstock the simply fabulous C/D of 3.52. Kudos, Overstock.
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. Hats off to all these companies for keeping their money on the right side of the balance sheet.
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 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 1.11, eBay is solid on this benchmark.
- But Google does even better, with a Foolish Flow ratio of 0.76.
- Amazon beats Google, with a ratio of 0.62.
- And Overstock surprises everyone, with a ratio of 0.41.
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.
Again, anyone who's online knows eBay, and name recognition is instant. It's a testament to not only how long it's been around (which, in Internet terms, is practically forever), but also to its usefulness. And its business model is dead easy to understand: People put items up for auction, others bid on and buy them, and eBay gets a cut.
A Rule Maker among Rule Makers
eBay hits almost every metric out of the park. Even among Rule Makers, there aren't that many companies out there like eBay. But please do remember to check in on eBay, or any other Rule Maker in which you hold positions, at least once a quarter, and run them through this simple checklist.
In Rule Breakers, Rule Makers, Tom Gardner goes into even greater depth and detail about what exactly makes a Rule Maker. 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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