By Miguel Alexander,2014-07-11 19:36
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    Financial Statements Analysis and Valuation of

    McDonald’s and YUM

    -Purpose and Structure

    To get insight into MacDonald’s (MCD) and YUM, this report conducts profitability and

    growth sustainability analysis followed by common size and trend comparison between these two firms. On the basis of ratio analysis, valuation of two firms is performed. - Analysis of Financial Statements

     Profitability. The Return on Common Equity (ROCE) is predominantly driven by Return on Net Operating Assets (RNOA) and Financial Leverage (FLEV) in both firms. Notably, it is the FLEV that mainly affects the gap between MCD and YUM.

    ROCEResidual Earnings Growth100.00%4000MCDO

    McD NALDS200050.00%AEGYUM

    0Yum 0.00%AEG2007200820092010-20002007200820092010

     Growth Sustainability. Changes in ROCE and Common Shareholders’ Equity (CSE) are

    the core components of Abnormal Earning Growth. Decomposition analysis presents that both the core RNOA and CSE growth shows a stable upward trend. Consequently, both firms have the ability to obtain sustainable growth potentials.


    Models Value per share/MCD Value per share/YUM

    RE $ 138.35 $ 63.51

    ReOI $ 149.08 $ 65.17

    Abnormal RE $ 138.35 $ 63.51

    Abnormal ReOI $ 149.08 $ 65.17

     The valuation results, based on analysis of financial statements and estimates of growth and discount rate indicate that both MCD and YUM are undervalued and investments of both firms are recommended.


     Based on our analysis and forecasts, both companies are expected to remain a consistent and healthy growth in sales and net income, generating satisfactory return for its shareholders. The promising prospects of both companies make them valuable investments.


1. Reformulation of Financial Statements

     To indentify different effects of operating and financing activities, we reformulate the GAAP financial statements and calculate key indicative ratios (Appendix A and B). 2. Analysis of Financial Statements

    2.1 Profitability Analysis

    The rough profitability comparison shows the substantial disparity of ROCE between the MCD and YUM (Graph 1). In general, YUM is about 40% higher than MCD in terms of ROCE. In years 2009 and 2007, YUM’s ROCE is nearly twice as much as that of MCD. The

    first level breakdown indicates that YUM outperforms the MCD in all three driversRNOA

    (return on net operating assets), financial leverage and operating spread. The most distinct discrepancy attributes to the financial leverage: on average, YUM’s financial leverage is

    approximately 150% higher than that of MCD (Graph 2). Therefore, despite mild differences in RNOA, YUM’s favorable financial leverage gear up the RNOA to yield much satisfactory

    return for its shareholders.

    YUM’s RNOA is about 11% higher than that of MCD. Analyzing RNOA from the

    operating leverage perspective reveals that ROOA and spread shows similar pattern and little difference excerpt for the operating leverage. YUM’s operating leverage averages at 0.35

    while MCD remains at 0.22 (Graph3). It suggests YUM is savvier in operation and employs less net operating assets and levers up return on operating assets.

    The second level breakdown suggests the reasons for difference in operating profitability as well as their business strategy. MCD’s profit margin is roughly twice that of YUM and

    keeps a steady climbing trend. With respect to the asset turnover ratio, YUM remains an above-two ATO while MCD only levers at one (Graph4). It seems that MCD focuses on increasing the profitability per dollar of sale while YUM puts more emphasis on improving


    efficiency, generating more sales per dollar of operating assets. In the highly competitive and fragmented restaurant business, YUM’s emphasis on enhancing efficiency and aggressive expansion is quite sensible while MCD’s philosophy to building one brand through time and

    increasing profitability is also remarkable.

    2.2 Analysis of Growth Potential and Earnings Sustainability

     Residual Earnings = (ROCE Cost of Equity Capital ) ×CSE (1) t ttt-1

    The formula (1) has displayed the changes in residual earnings are driven by two major components, ROCE and CSE. Therefore to analyze whether the growth of the firm will persist, the following section provide a detailed analysis on changes in both ROCE and CSE.

    Table 1 Residual Earnings Growth Decomposition

    MCD Residual Earnings Growth 2007 2008 2009 2010

    Residual earnings (at cost of equity of 7.15%) 2866.95 2021.72 4225.43 3934.47

    Abnormal Earnings Growth(REt-REt-1) n/a -845.23 2203.72 -290.97

     Change due to (ROCE Cost of equity) n/a -581.61 2364.09 -489.56

     Change due to CSE variation n/a -263.62 -160.37 198.59

    YUM Residual Earnings Growth 2007 2008 2009 2010

    Residual earnings (at cost of equity of 9.80%) 859.58 361.6 1106.91 925.41

    Abnormal Earnings Growth(Ret-Ret-1) n/a -497.98 745.3 -181.5

     Change due to (ROCE Cost of equity) n/a -295.79 750.13 -724.91

     Change due to CSE variation n/a -202.19 -4.83 543.41

    Note: Cost of equity is calculated by CAPM and beta is obtained from Thomson One Banker. Level 1: Analysis of Changes in ROCE. The equation (2) has presented growth

    sustainability of ROCE is divided into three subsections: the effects of change in operating profitability, the effects of change in leverage and change in spread.

    ???? ?:;?,??:(;;?!,,??;,:,;??;,:,;??!,,? (2) :?,

    As is clearly displayed in the Appendix B-5, the overall ROCE for both firms has presented a similar pattern that ROCE declined dramatically from 2007 to 2008 but soared up to a peak


    in 2009, followed by a significant drop in 2010. However, the major drivers accounting for the fluctuations are different: For MCD the changes in operating profitability contributes to the most of the changes in ROCE while the operating spread is the major factor that changes the overall ROCE in YUM.

    Level 2: Decomposition of RNOA and Spread. Over 2007 to 2010, the core RNOA in

    both firms displays a steady upward trend, from 18.46% to 21.67% (MCD) and 20.15% to 25.75% (YUM) respectively (Appendix B-9 and B-14). Graph 5 and 6 present the decomposition of changes in RNOA for both companies. Taking out the unusual items which are not persistent in the future growth, MCD has got a more stable figure in core profit margin, asset turnover and core operating income. On the contrary, the core operating income and profit margin in YUM present a more volatile pattern. The operating spread is another major concern for future growing potentials. As is shown in Graph 7 and 8, net borrowing costs has little impact on both firms’ operating spread, contributing to close zero. The major factor that

    drives change in spread is again the RNOA.

    10.00%10.00%Core PMCore PM


    0.00%Core OI0.00%Core OI200820092010-5.00%200820092010Unusual -5.00%Unusual ItemsItems-10.00%

    Graph 5 MCD RNOA Decomposition Graph 6 YUM RNOA Decomposition

     To conclude, the major driver for ROCE in both firms is Return on Net Operating Assets, which affects the ROCE growth and indirectly influences ROCE through operating spread. Level 1: Analysis of Changes in CSE. As is shown in formula (2.3) the changes in

    common shareholders’ equity is the other critical component of residual earnings growth. Based on 2007, the changes of NOA and NFO in MCD and YUM suffered from financial crisis in 2008 and grew steadily afterwards (Appendix B-10).

     ??;,???;???() ;~;???(!; (3)

    Level 2: Decomposition of CSE Growth. From the following graphs, changes in CSE are

    driven by sales, asset turnover and changes in net financial obligations. There is no obvious pattern for both of firms and all of the three factors have significantly influenced the growth in CSE.


    Graph7:McD CSE Growth Graph8:Yum CSE Growth


    2000.00 2000.00

    0.00 0.00 200820092010-2000.00 200820092010

    -4000.00 -2000.00

    SalesATONFO growthSalesATONFO growth

     To summarize, both firms have retained substantial residual earnings and the analysis of abnormal earning growth shows that MCD and YUM have the ability to obtain sustainable growth potentials since the major drivers (Core RNOA and change in CSE) present a stable upward trend.

    2.3 Common size and trend analysis.

    From the common size income statements charts (Appendix B-15), MCD is average 10% lower in the cost of sales and thus has a higher gross margin compared with that of YUM. The nearly 5% lower in total operating expenses of MCD can be further reflected in the average 9% higher in operating income from sales after tax. In terms of the operating profitability per dollar of sales, both firms experience an increase in profit margin and MCD’s average profit

    margin (19.33%) nearly double that of YUM (10.24%). Except for 2009, MCD and YUM comprehensive net profit margin i.e. comprehensive income index, decrease compared with their operating profit margin, implying that the financial activities have decreased the profits. The common size balance sheets show that net property and equipment account for the majority of the operating assets in both firms, as MCD is 75.58% and YUM is 57.24% on average. Furthermore, the key indicative ratios we calculated remain in a consistent and reasonable range.

    Trend Analysis of Income Statement-YUM!Trend Analysis of Balance Sheet-YUM!150%150%Cost of salesAccounts and notes 140%140%receivable130%130%Operating Inventories120%revenues120%110%Gross margin110%100%Property and 100%90%equipment, netTotal operating 90%80%expenses80%70%Total operating operating income assets70%60%frome sales( 50%60%before tax)Accounts payable Percent of 2007 ValueOperating income 40%50%Percent of 2007 Valueand other current after sales(after liabilities2007-1-12008-1-12009-1-12010-1-12007-1-12008-1-12009-1-12010-1-1tax)

    The trend analysis of 2007 value basis depicts the changes of financial items. In 2008, both


    firms slightly decreased their investments in operations by 3%-4% followed by a rise in the subsequent years as indicated by the index for net operating assets. In terms of the activity ratios, MCD’s average days in account receivable is 16.56 and YUM’s is 7.89, indicating that

    YUM needs fewer days to collect cash from sales and thus more efficient in operations. On the contrary, MCD’s average days in inventory is 3.28 while YUM’s is 6.36, implying MCD’s

    holds inventory for fewer days and superior inventory management.

    Comprehensive income and total operating income of two companies fluctuate during this period. Although plummeted in 2008, both firms achieved a growth of around 22% (MCD) and 8.5% (YUM) in 2010. Cost of sales of MCD has grown slower than operating revenue, resulting in a higher growth rate in gross margin. Similar trend is found in YUM. Net operating assets of MCD grows slightly slower than operating revenues, indicating more revenues have been earned for each dollar invested in the operating assets. Opposite trend appears in YUM as net operating assets grow faster than operating revenues, leading a decline in sales earned per assets invested, except for 2008. YUM’s operating revenues grew by 4.7% in 2010, but the corresponding inventories growth rate was 54.9%. The growth comparison of sales with expenses and account receivables shows satisfactory operation of both companies. 3. Valuation of MCD and YUM

    3.1 Forecast

    In order to calculate the value of common equity of MCD and YUM, we adopt following four models: Residual Operating Income Model, Residual Earnings Model, Abnormal Earnings Growth Model and Abnormal Operating Income Valuation Model. Some essential estimates including Gross margin ratio, Sales growth rate, SG&A expense ratio, Tax rate and Asset turnover have to be made first so that those models can be applied accurately. Estimates of Sales Growth: For MCD, the sales growth of 2010-2011 is 5.8%. The

    declaration of future sales can be found in MD&A: ―In 2010, strong global sales and margin performance grew cash from operations, which rose $591 million to $6.3 billion‖. Besides, a significant part of the operating income is found to be generated outside the U.S., especially in Asia. MCD is looking for growth in fast growing emerging markets where the recent economic downturn has had much less impact on consumer spending. In Malaysia, MCD expects sales to be up by 20% in 2011; MCD plans to open another 175-200 new restaurants


    in 2011 in China which enjoys the fastest development. As a result, MCD has a strong power in generating more revenues in the coming years. Meanwhile, MCD is expected to incur more expenses. They stated in their outlook in 2011 that interest expense for the full year 2011 may increase approximately 7% compared with 2010. Moreover, the negative effects of financial crisis persist. Considering the information above, we estimate that MCD will keep a growth

    rate of 4.5% for the subsequent years.

    For YUM, the sales growth of 2010-2011 is 4.7%. YUM mentioned their goal is to maintain a growth of 6%-7% in the MD&A. From other information resources, Yum expects operating profit from international operations to account for 75% of its overall profit by 2015. Yum plans to open more stores in China which is generating a substantial part of its revenues. Furthermore, YUM is seeking expansion aggressively. YUM already holds a 27.2 percent stake in Little Sheep, a promising Chinese hotpot restaurant group. Therefore, the revenue of Yum will have a great potential as well. We make the estimation that YUM will keep a

    growth rate at 5% for the following years.

    Forecast on Gross Margin: In terms of gross margin, MCD and YUM are facing the same

    problem. The restaurant industry is highly competitive and is squeezing its profit margins. For MCD, the gross profit margin is 42.9% in 2010 and around 40% in recent 5 years. For YUM, the gross profit margin is 33.3% in 2010 and around 32% in recent 5 years. Based on the recent information, both Yum and MCD are suffering from permanent problem lies in the fact that increasing input costs for beef, chicken, corn, and other food products - along with oil and paper - will increase total input cost. What’s more, with the fast food industry being

    highly competitive, leading to easy availability of substitutes, they would be under pressure to increase prices. So we estimate the Gross profit margin in YUM and MCD will decline to 40%

    and 32% respectively in the future.

    Except for the above two forecasts, we assume that all the other financial ratios remain the same level of 2010 and no change in the book capital structure over time.

    3.2 Valuation

    Based on our forecast, we employ four different models to derive the estimated price for MCD and YUM. The prices are summarized in Table 2 and the calculation details are in Appendix C)


    Table 2 Valuation Results

    Value per share/MCD Value per share/YUM Models

    RE $ 138.35 $ 63.51

    ReOI $ 149.08 $ 65.17

    Abnormal RE $ 138.35 $ 63.51

    Abnormal ReOI $ 149.08 $ 65.17

    The MCD's close price on Dec 31, 2010 is $76.76, and YUM’s is $49.05. Compared with

    our valuation results, it is obvious that both MCD and YUM are underpriced. Moreover, the gap between the estimated price and the real price is quite huge. There may be several causes: First, the valuation is based on the estimates of sales growth and gross margin ratio. To sustain a sales growth of 4.5% over more than 5 years is a little overly optimistic. Second, for the Residual Operating Income Model and the Abnormal Operating income Growth Model, the limitation is that we assume debt and financial assets are zero residual earnings procedures; they add no value to their recorded value. However, this assumption is not practicable in real life.

    Last but not least, the cost of equity is calculated based on the CAPM model, but whether CAPM is an appropriate proxy of cost of equity is very doubtful. Moreover, we assume these two firms’ leverages are consistent, so the cost of equity can be fallible.

    In conjunction with our valuations and estimates, we conclude that both MCD and YUM are undervalued, and it appears to be attractive companies to invest as they also pay a large amount of dividends to investors every year.

    4. Conclusion

     In sum, we reformulated the financial statements of MCD and YUM. A thorough analysis is then conducted. Finally, the price for both companies at year end 2010 is estimated based on our forecast. Our analysis indicates the difference in their business strategy and operation YUM seems to promote the multi-brand strategy and aggressive expansion. It employs much higher leverageboth financial and operating leverageto lever up return and has

    remarkable efficiency in operations, which is reflected in high ATO. By contrast, The MCD’s

    philosophy is to build one brand over time and enhance loyalty and profitability, generating high return for shareholders in the long term. Finally, the comparison of estimated value and price suggests both companies are largely undervalued, making them attractive investments.



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