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-founders David and Tom Gardner laid out specific criteria for crowning a company a "Rule Maker": a mature, consumer-facing business that's king of its market space, and an investment that can confidently and profitably be held onto for years with only quarterly check-ins.
Their 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 payments-processing giant Visa (NYSE:V) through the Gardner brothers' merciless gauntlet and see exactly what makes it a classic Rule Maker.
1. The mass-market, repeat purchase of low-priced goods
You're likely already aware of this, but just in case you're not, Visa is not a bank. Visa processes electronic payments: moving money back and forth between your bank and the merchant you're buying something from. Visa makes its money by taking a percentage of each sale.
So when you swipe your credit card at your favorite sushi bar, download a song from your preferred online seller, or bump your smartphone against the payment terminal in your favorite coffee shop, Visa manages the behind-the-scenes electronic magic that makes it all possible.
As money moves more and more from being something folded up in your wallet to a burst of data sent between a seller and your checking account, services that companies like Visa provide are going to be more and more in demand. As such, Visa 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%.
- Visa's gross margin is 84%. No slacking here.
- MasterCard (NYSE:MA) has a gross margin 12 months trailing of 100%: a number beyond great.
- Discover Financial Services (NYSE:DFS) also hits 100% on this metric. Incredible.
- Finally, American Express (NYSE:AXP) has a gross margin of 77%.
This is an unusual batch of companies, in the best way possible. All of our them are exceptional on this metric.
3. Net-profit margin
Net-profit margin dictates how many pennies a company gets to keep from every dollar of sales. The Gardners like to see net-profit margins of 10% for Rule Makers.
- Visa's net-profit margin TTM is a staggering 42.79%.
- MasterCard's net-profit margin TTM is up there, too, at 29.73%.
- Discover beats MasterCard, with a net-profit margin TTM of 34.75%.
- American Express, by normal standards, has a great profit margin -- 17.12% -- until you look at it in relation to its peers.
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.
- Visa grew its revenue by 14.8%. Not too shabby.
- MasterCard got up to 9.2% YOY sales growth. Very healthy.
- Discover hit 8.8%. Solid.
- American Express managed only 0.8% YOY sales growth. Not so solid.
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:
- $3 billion in cash and zero debt give Visa the best cash-to-debt position possible.
- The same goes for MasterCard, with $5 billion in cash and zero debt.
- $6.4 billion in cash and $19.5 billion in debt gives Discover the unenviable C/D of 0.32.
- $25 billion in cash and $60 billion in debt gives American Express the only slightly less unenviable C/D of 0.42.
Money is so cheap right now. A little too cheap. As such, too many companies are in debt up to their corner offices. Kudos to Visa and MasterCard for keeping their coffers full and their debt low.
6. The Foolish Flow Ratio
The Foolish Flow Ratio measures how well a company manages its inventory and cash. 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:
- Visa hits a lovely, low F/F of 0.55.
- MasterCard also hits a lovely, low F/F: 0.57.
- Finally, American Express also does very well, with an F/F of 0.79.
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.
You know Visa because, chances are, you use a Visa-branded credit card now or have at some time in the past. If you understand that Visa makes a percentage of every sale on the planet it processes -- a beautiful, dead-simple concept -- you get how Visa makes money, which makes it a better investment for you.
Visa: quite possibly everything you want an investment to be
Visa is a Rule-Making monster. You don't often run across a Rule Maker that significantly exceeds or blows away each and every metric the way Visa does. As such, it might just be the Rule Maker of all Rule Makers.
But always remember to check in on your Rule Maker investments once a quarter by running them through this simple checklist. In Rule Breakers, Rule Makers, David and Tom go 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 men who wrote the book on it.
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Fool contributor John Grgurich owns no shares of any of the companies mentioned in this column. Follow John's dispatches from the bleeding edge of capitalism on Twitter @TMFGrgurich. The Motley Fool owns shares of MasterCard. Motley Fool newsletter services have recommended buying shares of V. The Motley Fool has a strangely gripping disclosure policy.