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 mature, consumer-facing company that's king of its market space, and an investment that can be confidently and profitably held on to 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 soda giant Coca-Cola (NYSE:KO) 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
Do you get much more "mass-market, repeat purchase" than bottles and cans of soda? Maybe diapers, if you're in possession of an infant, or cars, if you're a Hollywood stuntman. For this Rule Maker metric, then, Coke is as good as it gets.
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 60% in the trailing 12 months, Coke hits our second Rule Maker metric flush on the button.
- Perennial rival PepsiCo (NYSE:PEP) does admirably well here, at 52%.
- Dr Pepper Snapple Group (NYSE:DPS) does even better, with a gross margin TTM of 57%.
- Monster Beverage (NASDAQ:MNST), the newcomer to this classic club, ties Pepsi, at 52%.
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, Coke, hits a giant 18.34% net-profit margin TTM.
- At 9.05%, Pepsi can't touch Coke's performance, but performs well against our Rule Maker benchmark.
- Dr Pepper, however, is bang on top of things with a net-profit margin of 10.05% TTM.
- And Monster has a positively monstrous net-profit margin: 17.23%.
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.
- Coke disappoints on this metric, with only 3% YOY revenue growth.
- And so does Pepsi, with a revenue decline of 2% YOY.
- Dr Pepper matches Coke, at 3%.
- Monster blows everyone away, with YOY sales growth of 28%. Yes, 28%.
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:
- $17 billion in cash and $32 billion in debt give Coke a C/D of 0.53.
- $4 billion in cash and $28 billion in debt give Pepsi a C/D of 0.14.
- $312 million in cash and $2.8 billion in debt give Dr Pepper a C/D of 0.11.
- Finally, $158 million in cash and $169 debt give Monster the best C/D, 0.93.
Except for Monster, all of these companies need to get their acts together when it comes to their cash/debt positions. With lending rates as cheap as they are, 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 cash in the bank to see it through. Kudos to Monster on this metric.
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 0.46, Coke's FF ratio is very healthy.
- Pepsi is also solid on this metric, with an FF of 0.76.
- Dr Pepper is running a tight ship, as well, with an FF of 0.63.
- Monster? Not so much, with an FF of 1.82.
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.
Coke sells things to drink. Period. They sell, you buy, you drink, and then you buy more. There's no great mystery in how Coke makes its money, and that's a good thing: You might want a little mystery in your novels, or your prime-time programming, but not in your investments.
Still the real thing
Coke misses on sales growth, but given the depressed state of the world economy, nobody's doing well in that department (except for Monster, a new company in its high-growth phase). Coke also misses on C/D, and it does need to dump some of that debt. But overall, Coke is a classic Rule Maker.
As older, more established companies, Rule Makers' beauty lies 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 a strong all-rounder -- and that's Coke.
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.
The Motley Fool owns shares of Coca-Cola and PepsiCo. Motley Fool newsletter services have recommended buying shares of Monster Beverage, Coca-Cola, and PepsiCo. The Motley Fool has a happening disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.