Which Fast Food Giant Is Best?
Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Return on equity (ROE) is a commonly used ratio which represents a company's efficiency at generating net income from shareholders' equity. A high ROE can lead to a high earnings growth rate if profits reinvested into the company achieve the same return as in the past. But simply comparing ROE values for different companies isn't enough - the question is what drives the return on equity? McDonald's (NYSE: MCD) and Yum Brands (NYSE: YUM) are the two largest quick-service restaurant companies in the world, and yet the way in which they achieve their above-average ROE is vastly different. In 2011 McDonald's posted a ROE of 31.59% while Yum posted an extraordinary 77.61%. We can break apart these values into their components and see what's driving them by doing a DuPont analysis.
What's a DuPont analysis?
In the 1920's the DuPont Corporation developed what became known as the DuPont analysis, which uses basic accounting identities to break down return on equity into either 3 or 5 component parts. I'll be using the more detailed 5-component version. The basic equation is below.
This equation is an identity because everything on the right-hand-side cancels out except Net income divided by Equity. Each of the five items is a component which, when multiplied together, yields the ROE.
Net income/EBT - This is the company's tax burden, or the proportion of a company's earnings which remain after taxes. 100% would mean the company paid no taxes, while 0% would mean all EBT went to taxes.
EBT/EBIT - This is the company's interest burden, or simply the percentage of EBIT remaining after interest is deducted. 100% would mean that the company paid no interest, while 0% would mean that all EBIT went to interest payments.
EBIT/Sales - This is the operating income margin, or return on sales.
Sales/Assets - This is the asset turnover, which represents the revenue as a percentage of assets. This can be over 100%.
Assets/Equity - This is the leverage ratio. The higher the number, the more leverage the company is using. A value of 1 represents no leverage.
By comparing these 5 numbers over time we can see what the driving force behind the ROE has been. And by comparing between companies we can see how they generate their ROE.
Let's do this analysis for both McDonald's and Yum. I'll calculate these values for 2008-2011 so that any trends become evident. Here is all the data we'll need.
All values in millions USD. Date from Morningstar
One note before I present the results of the DuPont analysis: since we're combining items from the income statement and the balance sheet I'll use an average value for balance sheet items. Since all of the income statement items occurred through the year while the balance sheet items are from snapshots at the end of the year, I'll take the average of the current year's value and the prior year's value for both assets and equity.
Here are the results of my DuPont analysis for both companies:
The big takeaway from this is that McDonald's has much higher margins than Yum, about a factor of two. A company that can sell cheeseburgers for a dollar and still maintain 30+% operating margin is doing something right. But even with this huge advantage Yum has a ROE twice that of McDonald's. Looking at the results this is due to Yum's use of leverage. Yum's leverage ratio has been declining since the financial crisis, but sill sits at 5.05 compared with 2.24 for McDonald's.
I've included return on assets, which is another useful measure, and you can see that both companies have very similar values. Both companies have increased their ROA since 2008, which is a good sign.
The trends look better for McDonald's than for Yum. Mcdonald's has seen its ROE increase steadily since 2008 while Yum has seen a stark decline. The trend for McDonald's has been driven by an increasing margin, slightly increasing asset turnover, and by utilizing more leverage. These effects combined allowed McDonald's to increase ROE by almost 8 percentage points. Yum, on the other hand, has seen asset turnover decrease along with its leverage ratio. Although margin has increased since 2008 it suffered a decline in 2011. This has led to a decreasing ROE.
The bottom line
This type of analysis says nothing about valuation, but is useful in comparing the operational efficiency of companies. Although Yum has achieved a higher ROE than McDonald's this number is heavily skewed by the use of leverage. McDonald's far superior margin, and the fact that it has increased consistently even through the financial crisis, leads me to believe that McDonald's has a more durable economic moat than Yum. I prefer companies which don't need to use leverage to achieve superior returns, and I think McDonald's is the clear choice here. Both are exceptional companies, though, and if the price is right either one would make for a good investment.
TheBargainBin has no position in any stocks mentioned. The Motley Fool recommends McDonald's. The Motley Fool owns shares of McDonald's. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!