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 laid 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 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 methodology will benefit even advanced investors. Today we're going to run entertainment giant Disney
1. The mass-market, repeated purchase of low-priced goods
The House of the Mouse. Is there a better-known entertainment franchise anywhere in the world? What corner of the planet hasn't been touched by Mickey, Minnie, or Goofy? And now, with the ever-brilliant Pixar Animation under its corporate umbrella, Disney is bigger, better, and more popular than ever.
If there's any entertainment company that could be said to be a "necessity," it's Disney. People need their fix -- especially kids, but adults, too. Disney, then, is a great example of a mass-market item with a limited lifespan that will need to be repeated over and over. Disney easily makes the Rule-Maker grade here.
2. Gross margin
Gross margin indicates pricing power and manufacturing efficiency. Per Tom Gardner, the ideal gross margin for a Rule Maker is 60%, but the entertainment business runs a bit differently than most, and the industry average is about 41%. Yet even given that bit of slack, Disney, with a gross margin of 19.73% trailing 12 months, or TTM, is lacking.
Peer DreamWorks Animation
3. Net-profit margin
As Tom Gardner so 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 many pennies a company gets to keep from every dollar of sales. Disney comes roaring back here with a net-profit margin of 12.13% TTM, easily making Rule-Maker status. Peer Time Warner
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. Disney disappoints here with year-over-year sales growth of just 0.6%. Peer News Corp.
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 Disney has $3.77 billion in cash and $14.39 billion in long-term debt, for a cash-to-debt ratio of 0.26. While this is far from ideal, the saving grace is that money is cheap right now, and with its theme parks, movie releases, and the like, Disney generates a lot of cash on a day-to-day basis, so it should easily be able to keep up with its debt payments.
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 and divide by current liabilities. The best companies have Foolish Flow Ratios of 1.0 or less. 1.25 is acceptable as the upper end. Disney's is a beautiful 0.87.
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.
Disney's is a dead-easy business model; the company makes movies, operates theme parks, and sells merchandise. Brand recognition is easily up there with Coca-Cola
Let's hear it for Rule Maker Disney
Disney is lacking on a few Rule-Maker fronts, but the company is solid enough that we can confidently call it a Rule Maker. Remember that Rule Makers are companies that 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 having to check in once a quarter. Disney does all of this.
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.
Of course, Disney isn't the only stock you can profitably and confidently hold onto 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 clamors for Pixar movies probably more than his three-and-a-half-year-old son does, but he owns no shares in any of the companies mentioned in this column. Follow John's dispatches from the bloody front lines of capitalism on Twitter@TMFGrgurich.
The Motley Fool owns shares of Coca-Cola. Motley Fool newsletter services have recommended buying shares of DreamWorks Animation SKG, Walt Disney, and Coca-Cola. 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's has a disclosure policy.