A perfect stock is one that is predictable, profitable, and cheap. It is hard to lose money if you only buy stocks that meet all three criteria. Three stocks that currently meet those criteria are eBay (NASDAQ:EBAY), McDonald's (NYSE:MCD), and Coca-Cola (NYSE:KO).
When I say predictable, I mean a company that does the same thing year after year and gets the same results year after year. eBay facilitates online auctions and processes online payments, McDonald's serves fast food, and Coca-Cola sells carbonated soft drinks. Each company acquires other businesses and has unrelated operations from time to time, but the core of each company's operations remains the same. This sameness is vital to an investor's analysis; it would be impossible to gauge eBay's long-term earning power if it were constantly changing its business model. A consistent model with a long track record provides invaluable clues as to the potential of a business.
Another part of predictability is the tendency to earn the same level of profit per item sold each year. A company that generates a consistent profit margin each year is likely insulated from competition and has control over its prices. Over the last ten years, eBay, McDonald's, and Coca-Cola generated remarkably consistent free cash flow margins; none fluctuated more than 20% from the mean in most years -- extremely low rates of fluctuation.
Moreover, a predictable profit margin can be sustained by each company due to its respective competitive advantages. eBay's auction business offers a platform for millions of sellers to reach millions of buyers -- a valuable network effect that would be near-impossible for a new entrant to replicate economically. PayPal is the leading online payment processor -- a company that customers and merchants alike understand and trust. It will be difficult for a similar company to emerge.
McDonald's operates in an industry where few competitive advantages exist, but it uses its enormous scale to extract concessions from suppliers, attract the best franchisees, and appeal to a worldwide consumer base. As a pioneer in the quick-serve restaurant industry, McDonald's continues to benefit from its first-mover advantage, and only a mass consumer migration away from fast food can impede its earning power.
Like McDonald's, Coca-Cola earns predictable profits due to its unmatched scale. It has a distribution network that no other competitor can replicate and a brand that consumers worldwide can identify. As with McDonald's, Coca-Cola's competitive advantages are too great for a rival carbonated-beverage company to overcome; the only plausible cause of declining profitability is a mass consumer migration away from carbonated soft drinks.
eBay, McDonald's, and Coca-Cola have competitive advantages that allow them to earn predictable profits each year. This makes it relatively easy to determine each company's earning power (before growth), which means we can be fairly certain of whether or not Mr. Market is offering us a good deal.
Just because a company is predictable does not mean that it is profitable. When I say profitable, I mean the money that it invests in its business produces a large amount of earnings relative to the money invested. A company that reinvests shareholder capital at a low rate of return destroys value, whereas a company that reinvests cash at a high rate creates value. We want to buy business with a long track record of creating value for shareholders.
My favorite profitability metric is return on invested capital, or ROIC. ROIC is calculated by dividing pre-tax earnings by invested assets (total assets minus excess cash and working capital). A good ROIC is the same as a good return in your stock portfolio; a company that consistently earns an ROIC above 10% creates a lot of value. eBay, McDonald's, and Coca-Cola all earn greater than a 10% ROIC.
The final qualification for a perfect stock is that it must be cheap. Cheap means different things to different people. In general, cheap means an investor can expect a 10% or greater return on his or her investment in the stock.
There are various ways of determining one's potential return on investment, but I like to keep it simple. Predictable businesses generate predictable profits, so using the past as a guide to the future is a good starting point for predictable businesses. If you take the average free cash flow margin for each company and multiply it by their respective revenue over the last four quarters, you get the following normal pre-growth free cash flow (in millions):
If Coca-Cola continues to earn a 19.65% free cash flow margin -- a feat it has accomplished for many years now -- then it should generate $9.2 billion in free cash flow in the average year even if it never grows sales. If you divide $9.2 billion by Coca-Cola's market capitalization, you get a free cash flow yield of 5.1%.
For investors to get a 10% or higher return on Coca-Cola, the company would need to grow sales per share at close to 5% per year. For McDonald's investors to receive a 10% return, the company would have to grow sales per share by nearly 6% per year. For eBay, the necessary growth is just under 4% per year.
Over the last ten years, each company grew sales per share faster than the plug rate in the chart above. If they can accomplish a similar feat in the next decade, these stocks are perfect for any investor's portfolio.