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 business that's king of its market space, and an investment that can confidently and profitably be 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 entertainment legend Disney (NYSE:DIS) through Tom's merciless gauntlet and see exactly what makes it a classic Rule Maker. We'll also touch on the biggest Disney news of the week, possibly even the century: The purchase of Lucasfilm for $4.05 billion.
1. The mass-market, repeat purchase of low-priced goods
Disney. Is there a better-known entertainment franchise anywhere? Who on the planet doesn't know Mickey, Minnie, or Goofy? Or seen The Incredibles, Cars, or Toy Story? Or heard the mighty Thor's thundering hammer, or wanted a pair of Iron Man's jet boots?
And now, with the purchase of Lucasfilm, which will give Disney the rights to everything Star Wars and Indiana Jones, if Disney wasn't the world's premier entertainment force before, it is now.
And if there's any entertainment company that could justifiably be called a "necessity," it's the House of Mouse. People need their fix, kids and adults alike. Disney, then, is a perfect example of a company that makes mass-market, repeat-purchase goods -- because everyone needs to see Star Wars 16 times, like I did when I was a kid. As such, Disney easily makes our first Rule Maker grade here.
2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%.
- Disney's gross margin for the trailing 12 months is 21%. Not exactly the best.
- DreamWorks Animation (NASDAQ:DWA) does a bit better, with a gross margin TTM of 30%.
- News Corp. (NASDAQ:FOX) manages 38% here.
- And finally, Time Warner (NYSE:TWX.DL) has the best gross margin of all: 44%.
It must be noted that not all industries are created equal, and in some industries you're just not going to get to that 60% Tom Gardner so enjoys seeing. The industry average gross margin TTM for the entertainment sector is 36%, but even using that as a fill-in benchmark, it's clear that Disney could be doing better.
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.
- Disney's net-profit margin TTM is a more than healthy 13.18%.
- DreamWorks' net-profit margin TTM is very healthy, too: 9.69%.
- Time Warner is also very solid on this benchmark: 9%.
- News Corp., however, with a net-profit margin TTM of 3.5%, could obviously be doing much better.
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.
- With 3.9% YOY sales growth, Disney needs some help here.
- But up against DreamWorks' YOY revenue contraction of 25.4%, Disney's 3.9% looks just fine.
- Time Warner did poorly on this metric as well, with sales down by 4.1% YOY.
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:
- $4.4 billion in cash and $15 billion in debt gives Disney the unenviable C/D of 0.29.
- $9.6 billion in cash and $15.5 billion in debt gives News Corp. the slightly better C/D of 0.62.
- $81 million in cash and zero debt gives DreamWorks the best cash-to-debt situation possible.
- Time Warner's $2.5 billion in cash and $19.9 billion in debt leave it with the worst C/D out of the bunch: 0.13.
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 DreamWorks, at least, for keeping its coffers full and its 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:
- DreamWorks hits an FF that I don't think I've even seen before: 2.95. Ouch.
- Time Warner sneaks in just under the benchmark, with an FF of 1.21.
- Disney hits a lovely, solid FF of 0.93. Well done, Mickey.
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.
Everyone knows Disney, and everyone knows how they make money. They make movies, you pay to see them. They make related merchandise, you buy it. They run theme parks, and you pay big money for you and the kids to spend the day. A dead-simple business model that you, and most of the planet, just can't resist: quite possibly the perfect investment.
Mickey: Still making the rules in this town
Disney could have a better gross margin, it's true. Tighten up the ship a bit, CEO Mickey. Sales growth could also be stronger, and it could stand to have less debt on its books, but Disney remains a classic Rule Maker. Remember that Rule Makers don't have to knock every metric out of the park every quarter. They're primarily strong over the long term: slow but steady moneymakers that keep churning out profit and growth year after year, without necessarily breaking records along the way. That's Disney.
As such, 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, 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.
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. Motley Fool newsletter services have recommended buying shares of Walt Disney and DreamWorks Animation. The Motley Fool has a strangely gripping 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.