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 and CEO Tom Gardner lays out specific criteria for crowning a company a "Rule Maker," i.e., a large, 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 methodology will benefit even advanced investors.
Today we're going to run Starbucks
1. The mass-market, repeated purchase of low-priced goods
When CEO Howard Schultz founded Starbucks, one of the things he set out to do was create a "third place," i.e., a spot between work and home where people could hang out in a hip atmosphere while enjoying a superior cup of coffee.
He succeeded beyond his wildest dreams, and a stop at Starbucks has become a "necessity" for people around the world. The Starbucks experience, then, is a great example of a mass-market item with a limited lifespan that will need to be repeated over and over. Starbucks easily makes the Rule-Maker grade here.
2. Gross margin
Gross margin indicates pricing power and manufacturing efficiencies. Per Tom Gardner, the ideal gross margin for a Rule Maker is 60%. Starbucks' is a very healthy 56.4%. Dunkin Brands'
3. Net-profit margin
As Tom Gardner aptly puts it in the book, "The reward of high gross margin is surpassed only by the treasures of high net-profit margin." Net-profit margin tells us how much money a company gets to keep from every dollar of sales. Starbucks' is a Rule-Making 11.1%. McDonald's
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. Starbucks' YOY quarterly sales growth was a whopping 16.4%, easily making the Rule-Maker grade.
With 101.7% growth, Green Mountain Coffee Roasters
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. A look at the balance sheet shows Starbucks has $2.27 billion in cash and $549.5 million in long-term debt. This gives Starbucks a phenomenal cash-to-debt ratio of 4.13.
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 receivable low and its accounts payable high --strong indicators of market-space dominance.
To calculate the Foolish Flow Ratio, take current assets minus cash, cash equivalents, and short-term investments and divide by current liabilities. The best companies have Foolish Flow Ratios of 1.0 or less, though 1.25 is acceptable as the upper end. Starbucks' ratio is a beautiful 0.91.
7. Your familiarity and interest
What's in a name, you ask? Plenty. Your familiarity and interest help you understand exactly what a company does and how it makes money, thereby lowering your overall investing risk.
Starbucks is such a dead-easy business model; the company sells coffee and food. The brand is already iconic, too, and gaining more and more notice around the world as time passes and business expands. Brand recognition is probably up there with Coca-Cola, the world's greatest brand with another dead-easy business model, and a Rule Maker in its own space.
Let's hear it for Rule Maker Starbucks
Starbucks doesn't hit it out of the park in every category, but it solidly makes the Rule-Maker grade on all fronts, and that's what Rule Makers are supposed to do. That is, these companies are past their big-growth phases but have figured out how, year after year, steadily and consistently, to churn out growth and profit and let you make money while only checking in once a quarter.
In Rule Breakers, Rule Makers, Tom Gardner goes into even greater depth and detail about what exactly makes a Rule Maker. So I suggest you pick up a copy for yourself and get the whole story from the man who literally wrote the book on it.
Of course, Starbucks and Coca-Cola aren't the only stocks you can profitably and confidently hold on to for the long term. Learn about the stock The Motley Fool is calling its top pick for 2012 in this special free report, aptly titled "The Motley Fool's Top Stock for 2012." Get it while the stock is hot by clicking here now.
Fool contributor John Grgurich is actually in need of a "fourth place," if anyone out there has any ideas. He owns no shares of any of the companies mentioned in this column. Follow him on Twitter @TMFGrgurich. The Motley Fool owns shares of Starbucks and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Coca-Cola, McDonald's, Green Mountain Coffee Roasters, and Starbucks. Motley Fool newsletter services have recommended writing covered calls in Starbucks. Motley Fool newsletter services have recommended creating a lurking gator position in Green Mountain Coffee Roasters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.