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" -- that is, 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 telecom giant Verizon Communications (NYSE: VZ) through Tom's merciless gauntlet and see whether it has what it takes to make the Rule-Maker grade.
1. The mass-market, repeat purchase of low-priced goods
Verizon provides a blizzard of communications services that nearly 100 million people use in one form or another. The company provides everything from dial-tone landline to Internet to digital television to wireless service.
And if you're a customer, you happily and diligently pay your bill every month because, otherwise, what are you going to do without your communications services in our hyper-connected world? Verizon easily passes our first Rule-Maker test.
2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%. Verizon, at 59% for the trailing 12 months, essentially hits the mark. Rival AT&T (NYSE: T) does admirably well on this metric, coming in at 55%.
Sprint Nextel, however, manages only 42%. British Vodafone (Nasdaq: VOD) does even worse, with a gross margin of 32%.
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.
Vodafone comes out the best on this metric, with a net-profit margin of 14.99% TTM. AT&T comes in second, at 3.24% TTM, with Verizon third at 2.36% TTM. Sprint, with a net-profit margin of -9.72%, clearly comes in last.
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. At 4.6% year-over-year sales growth, Verizon could be doing better here, but 4.6% is solid.
At 1.8% YOY sales growth, AT&T clearly disappoints, though Sprint comes in at 5.1%. Unfortunately for Vodafone, it's sales are contracting, with a YOY revenue growth rate of -1.6%.
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. However, ratios like that don't fly in the capital-intensive world of telecom:
- $6.54 billion in cash and $51.6 billion in debt give Verizon a C/D of 0.13.
- $2.59 billion in cash and $65.71 billion in debt give AT&T the even more unenviable C/D of 0.04.
- $7.57 billion in cash and $22.27 billion in debt give Sprint the best C/D yet, 0.34, though it's by no means "good."
- Finally, $12.86 billion in cash and $53.74 billion in debt give Vodafone, like Sprint, a relatively good, though in absolute terms poor, C/D of 0.24.
With money as cheap as it is, companies in all industries are loading up on debt, and it's not healthy. Sure, debt payments might be low from a relative standpoint, but it's never wise to carry so much debt and so little cash.
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 then divide by current liabilities. The acceptable upper limit for the Foolish flow ratio is 1.25, but the lower the number, the better:
- Verizon comes in at a very healthy 0.74.
- AT&T comes in at an also healthy 0.64.
- Sprint does likewise, with an F/F of 0.72.
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.
Verizon, as one of the big two American telecom providers, has all the brand recognition it needs. And it has a business model that's very easy to get one's head around: selling communications services. The idea has been around for more than a century. Verizon scores well on this metric.
Three cheers for Rule Maker Verizon
Yes, the cash-to-debt ratio could be better, but so could that of all Verizon's rivals. Sales growth and profit margin could be higher but are solid and generally in line with the rest of the industry. Remember that Rule Makers, as older, more-established companies, don't have to hit every number out of the park. Their beauty lies in their longevity, and their ability to steadily generate revenue and profit quarter after quarter, year after year.
And please do remember to check in on Verizon or any other Rule Makers you have positions in at least once a quarter, and run 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, literally, wrote the book on it.
Of course, this isn't the only easy-to-understand 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: "The Motley Fool's Top Stock for 2012." Get it while the stock is hot.
