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 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 approach will benefit even advanced investors. Today we're going to run consumer-electronics avatar Apple (AAPL +1.20%) through Tom's merciless gauntlet and see exactly what makes it a classic Rule-Maker.
1. The mass-market, repeat purchase of low-priced goods
iPhones. iPods. iPads. Mac laptops and desktops. Not the cheapest of their kinds, in comparison with the competition, but Apple has still been shipping these beloved pieces of consumer electronics by the boatload (quite literally, as they're all made in China) seemingly forever.
And of course, Apple users keep coming back for more, whether they've worn holes in their touchpads or just want the latest and greatest that the company has to offer. As such, Apple 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%.
- With a gross margin of 44% over the trailing 12 months, Apple falls well shy of our benchmark. More on that in a moment.
- Rival electronics maker Hewlett-Packard (HPQ 0.15%) manages 23% here.
- Research In Motion (RIMM 3.38%), maker of the BlackBerry, does a bit better, with a gross margin TTM of 29%.
- And finally, search and software giant Google (GOOG 0.15%) hits our gross margin benchmark right on the button, at 60%.
While 60% is Tom Gardner's ideal gross margin for a Rule Maker, in some industries that's just not possible, and consumer electronics is one of them. It's just the nature of the beast. And Apple does hit the industry average of 44% for TTM gross margins, so we can safely say that Apple is solid on this Rule-Maker metric.
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.
- Apple's net-profit margin TTM is a whopping 26.9%.
- HP's net-profit margin TTM is an unwhopping -4.5%.
- RIM's net-profit margin TTM, at -4%, is also heading in the wrong direction.
- Finally, Google's net-profit margin TTM is a clearly whopping 22.2%.
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.
- Apple grew its revenue by a big 22.6% YOY.
- HP's revenue contracted by 4.9% YOY.
- RIM's revenue also contracted, by a staggering 31.1%.
- Google beat the living daylights out of everyone on this metric, with YOY revenue growth of 45.1%.
5. Cash-to-debt ratio
Rule Makers should be cash-heavy and debt-light, ideally having at least 1.5 times as much cash as debt:
- $27 billion in cash and zero debt give Apple the best cash-to-debt position possible.
- $9.5 billion in cash and $29.8 billion in debt give HP the unattractive C/D of 0.32.
- $2.1 billion in cash and zero debt give RIM, like Apple, the best possible cash-to-debt position.
- Finally, $45.7 billion in cash and $7.9 billion in debt give Google the beautiful and rarely seen C/D of 5.78.
Money is so cheap right now. Too cheap. As such, too many companies are in debt up to their corner offices. Kudos to three of these companies 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, 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:
- Apple hits a lovely, low F/F of 0.73.
- HP hits a solid F/F of 0.91.
- RIM comes in with a rough F/F of 1.56.
- Google hits a very healthy F/F of 0.76.
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.
Apple is arguably a well known brand, planetwide, much as Coca-Cola is, and that's saying something. And chances are you, dear Foolish reader, own or have owned something that Apple makes -- at the very least an iPod -- so you have a good idea of what it does and how exactly it makes money. Apple easily makes this final Rule-Maker benchmark, then.
Apple, still the one
Apple missed only one of our benchmarks (gross margin, which we explained already) and knocked the rest of the out of the park. There's really no question that Apple is a Rule Maker in every sense of the word.
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, 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.
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