McDonald's or Yum! Brands – Which Should Be Your Long-term Bet?

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Mar 19, 2015
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For someone who is looking at initiating or expanding his or her position in a restaurant stock, the very obvious question is whether to put the money on McDonald’s (MCD, Financial) or on Yum! Brands (YUM, Financial). Both are big names in the industry and have vast span of operations, serving consumers across the globe. So, the answer isn’t the most obvious one, and requires a little digging in. That’s exactly what we are about to do.

Stacking up against each other
In comparison to Yum!, McDonald’s is a much larger company (2.7 times larger) by market capitalization and even in terms of business volume or profits. Yum’s trailing twelve month (ttm) revenue comes to $13.3 billion, where as McDonald’s stands at $27.4 billion. Price/Earnings ratio which says how much an investor is willing to pay for each dollar of earnings is lower for McDonalds at 19.96x, against Yum’s 33.94x. This means compared to Yum, McDonald’s is cheaper though both are in the same industry. In terms of Price/Sales, investors will have to pay more for each dollar of sales, but will have to pay a lot less for each dollar of book value when investing in the Big Mac maker. Even the profit margin and operating margin that McDonald’s offers are much higher, suggesting that the company is being run in a more efficient manner.

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Source: Yahoo Finance

The place where McDonald’s takes a beating is ROA and ROE. Yum offers much higher ROA and ROE and this implies that the management is able to manage its assets better and offer more satisfactory returns to the shareholders. However, we must not miss the fact that Yum is a highly leveraged company compared to McDonald’s and in isolation also. This makes the company more risky.

Valuation
Apart from considering financial ratios, it’s also very important to assess the value that the stock provides and compare that with the price it asks. For this purpose I have used GuruFocus’ fair value calculator and the following image helps explain how these two companies are valued.

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Source: GuruFocus

As of this writing, McDonald’s stock is trading at $97.0 and Yum is trading at $78.71. As per the calculations, McDonald’s fair value or intrinsic value comes to $105.33 a share, suggesting the stock is currently undervalued and thus is available at an 8% discount. If we consider the high target of $115.00 that Yahoo Finance analysts expects from the stock, the Margin of Safety increases further. Coming to Yum, the stock’s fair value is $37.25 and this suggests the stock is trading at huge premium and is already overvalued. Margin of Safety, which legendary investor Warren Buffet considers to be very crucial while judging a stock, is not favoring Yum at a negative 112%. GuruFocus business predictability for McDonald’s is four stars, while that for Yum is three stars – the average gain of all four star stocks comes to 9.8% per year, while that for three star stocks comes to 8.2% per year.

So, all this is painting a mixed picture. While Yum’s some of the metrics suggest better efficiency in operations, some suggest McDonald’s better returns. McDonald’s also scores when it comes to the intrinsic value and margin of safety calculations. I personally believe in going by the value a stock has to offer, and thus McDonald’s becomes the choice for me. Analysts and industry experts are positive about the stock’s upside potential – 26 out of 27 Yahoo Finance analysts have faith in the stock.