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Domino’s Pizza is the third largest publicly traded fast-food chain in the world. With over 18,800 locations worldwide, the business model is three pronged with franchising as the primary profit center. However, it has one glaring flaw, the company is highly leveraged to the tune of more than $5 Billion. There is ZERO equity in this company. It’s average annual earnings over the last five years are around $380 Million. The interest expense alone has almost doubled from $99 Million in 2016 to $192 Million in 2021; this is in five years.
Even with an average annual earnings of $525 Million per year, it will take 10 years to get the debt under control. Domino’s Pizza Inc. keeps recapitalizing its debt every couple of years. This recapitalization process increases the aggregated interest paid and given the current Federal Reserve’s attitude towards interest rates, this is going to be a detrimental problem for Domino’s in a few years. The weighted average borrowing rate is currently 3.8% and will remain stable for several years due to timing issues. However, there is a $1.2 Billion refinancing requirement in 2025 which will most likely result in an increase in the average borrowing rate. Thus, the ability of Domino’s to continue profitability at more than $600 Million per year after 2025 is questionable.
To add additional risk to the shareholders, the respective notes require that if Domino’s Pizza Inc. fails to comply with the terms of the respective notes, the notes are guaranteed by the royalties Domino’s generates. In effect, the respective note holders even move to the top of the income statement in front of expenses to operate Domino’s if Domino’s fails to make their obligated interest debt service payments.
What does all of this mean?
It means that Domino’s Pizza Inc. is a high-risk, low-reward investment at the current market price. There is no foreseeable value to a shareholder other than dividends. Its current cash flows indicate that any excess cash is used to buy back stock at current market prices shifting intrinsic value out of the company via treasury stock. Current dividends per share are $3.96 with a current market price per share of $380 (Mid-April 2022) generating a yield of 1.04%. The standard for a reasonable dividend yield with reasonable risk exposure is around 2.8 to 3.1% making this stock’s MAXIMUM value around $132 per share. But the key term here is ‘REASONABLE RISK‘ and Domino’s risk is simply off the charts with a leveraged position of $5 Billion. A more realistic dividend yield given this risk exposure is more than 4.5% making the maximum an investor would want to pay around $88 per share.
Another approach towards evaluating intrinsic value is to use the Graham and Dodd formula for total earnings less total debt. Current average earnings using a weighted based formula giving greater emphasis on more recent earnings results in the following estimated outcome:
Value = [Earnings X ((8.5 + (2X Growth))] Less Debt
Value = [$480M X ((8.5 + (2X 4.25%))] – $5 Billion
Value = [$480M X 17] – $5 Billion
Value = $8.160 Billion – $5 Billion
Value = $3.16 Billion
There are currently 36.14 Million shares outstanding. This means each share is worth approximately $87.44.
The key to this formula is the growth rate; notice that it is set at 4.25%. This growth rate is strongly tied to the increase in the number of stores worldwide. During the last three years, the number of locations increased 18.4% which averages more than 5% per year. Based on this, an analyst would assume a stronger growth rate than the 4.25% used; however, growth isn’t purely based on location increases. Growth is a function of not only increases in locations, but increases in revenue. Revenues per location have not kept pace. Average annual sales increases per store is less than 4%; thus, weighing down the overall growth rate.
Finally, related to the Graham and Dodd model, their formula assumes reasonable risk factors for the entity’s analysis. As stated already, Domino’s Pizza Inc.’s risk is unreasonably higher due to many factors. The most onerous being the lopsided balance sheet. Therefore, the formula’s result of $87.44 is quite liberal; the actual value is dramatically lower.
Overall, the intrinsic value of this company has been gutted by several factors:
- A leveraged debt position of more than $5 Billion;
- Interest payments that have almost doubled in five years;
- Cash Flows that are oriented towards buying back stock and not reducing debt;
- A business model that is highly dependent on expansion of locations to generate growth in revenue.
Domino’s Pizza Inc. – Intrinsic Value
Value investors are keen to risk reduction and as such, intrinsic value is determined from a position of reasonable risk and stability. Domino’s has no reasonable risk as an investment. This drives intrinsic value much lower. Furthermore, Domino’s Pizza is highly dependent on growth from franchise expansion to increase revenues and the bottom line. Domino’s business model requires a deep discount against intrinsic value in order to substantiate ownership of any securities in Domino’s Pizza.
Given the above information, intrinsic value is set at $70 per share with a buy price set at a 25% discount to intrinsic value, $52.50 per share.
Domino’s Pizza Inc’s current stock market price is driven by Domino’s Pizza Inc.’s growth model and not founded in sound financial analysis. This company is going to have many years of financial woes even with good growth. Act on Knowledge.
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]]>When a company performs to this level, intrinsic value soars. Intrinsic value is built on a company's inherent worth. The more stable and reliable a company, the greater the intrinsic value for that company. The reason is simple, the discount rate used with evaluating earnings improves because management demonstrates that it can indeed perform and in this case, perform at exceptional levels.
What is even more fascinating is this:
If you look at McDonald's balance sheet, total assets on 12/31/21 are $53.8 Billion; total liabilities are $58.4 Billion. McDonald's has a NEGATIVE EQUITY POSITION OF $4.6 BILLION. You read that correctly. In simple layman's terminology, this is called 'Bankrupt'. Every business textbook used in college defines bankruptcy as liabilities exceeding assets. This makes McDonald's performance just that more impressive. They are so solid, even creditors ignore this situation and will still loan money to McDonald's. During 2021, McDonald's was able to acquire long-term loans totaling $1.154 Billion. To further validate the incredible worthiness of McDonald's, from page 57 of their filed SEC Form 10-K (annual report), "There are no provisions in the Company's debt obligations that would accelerate repayment of debt as a result of a change in credit ratings or a material adverse change in the Company's business." You can only count on one hand the number of companies that have this level of credit.
McDonald's is financially rock solid.
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]]>A Value Investment Fund White Paper on McDonald’s Corporation
“to be our customer’s favorite place and way to eat and drink” – McDonald’s Mission Statement
President, Chief Executive Officer and Director of McDonald’s Inc. said it best in the earnings call in late January 2022, we are “… witnessing the beginning of the next great chapter at McDonald’s, …“. He continued with “2021 was a record-setting year for McDonald’s on many dimensions, …” Simply put, McDonald’s (MCD McDonald’s Corp. stock) had the best financial performance ever in its history during 2021. It just didn’t marginally exceed records, McDonald’s dramatically surpassed all financial records in its entire history. McDonald’s was already the standard bearer in the informal-eating-out industry; it took this standard to a whole new level. When a company has net profits of more than 20%, it is labeled a ‘darling’; over 25%, it is just unheard of with financial results; in 2021, McDonald’s net profit was greater than 32%; and this is after taxes. This sets such a high standard for fast-food restaurants; it is unlikely to be matched by others – EVER.
When a company performs to this level, intrinsic value soars. Intrinsic value is built on a company’s inherent worth. The more stable and reliable a company, the greater the intrinsic value for that company. The reason is simple, the discount rate used with evaluating earnings improves because management demonstrates that it can indeed perform and in this case, perform at exceptional levels. The discount rate is synonymous with risk; as risk decreases, the discount rate decreases.
What is even more fascinating is this:
If you look at McDonald’s balance sheet, total assets on 12/31/21 are $53.8 Billion; total liabilities are $58.4 Billion. McDonald’s has a NEGATIVE EQUITY POSITION OF $4.6 BILLION. You read that correctly. In simple layman’s terminology, this is called ‘Bankrupt‘. Every business textbook used in college defines bankruptcy as liabilities exceeding assets. This makes McDonald’s performance just that more impressive. They are so solid, even creditors ignore this situation and will still loan money to McDonald’s. During 2021, McDonalds was able to acquire long-term loans totaling $1.154 Billion. To further validate the incredible worthiness of McDonald’s, from page 57 of their filed SEC Form 10-K (annual report), “There are no provisions in the Company’s debt obligations that would accelerate repayment of debt as a result of a change in credit ratings or a material adverse change in the Company’s business.” You can only count on one hand the number of companies that have this level of credit.
Even without a positive equity position on the balance sheet, McDonald’s is still financially rock solid.
Knowing this, how does a value investor go about determining intrinsic value for McDonald’s? You can’t use the typical balance sheet formulas, technically they are bankrupt, and most definitely none of the equity formulas will work with the exception of dividend yield. Thus, a value investor must turn to either income statement based formulas or cash flow models. But before exploring these two alternatives, a value investor must first understand McDonald’s business model.
The business model is critical when evaluating intrinsic value. Knowledge of the business model greatly affects intrinsic value formula discount rates (to be explained) and the business model provides some insight into how McDonald’s makes their money. With knowledge of the business model, value investors then determine the discount rate. This is done through a set of steps and in turn a narrow discount range is calculated. Once the discount rate is computed, value investors turn towards the appropriate intrinsic value formula to apply and then can build a matrix of intrinsic value outcomes. From these outcomes, a range of intrinsic value is developed and then narrowed further via some objective testing. Once a reasonable window of intrinsic value is established, a value investor can then set a margin of safety and now a value investor has a buy price and intrinsic value. Finally, the model helps to determine yearly step-ups (adjustments) to the intrinsic value outcome with certain preset requirements allowing the value investor to have a buy/sell decision model that will work for three to five years.
The first step is to understand McDonald’s business model.
McDonald’s Business Model
If you ask the common person what McDonald’s does, they will state that McDonald’s is a fast-food restaurant. Well that part is undeniable. But if you research their financials, notes and management responses to inquiries, you’ll discover that McDonald’s has three distinctly different businesses within their organization. Interestingly enough, the food service component is the worst financial performer of the three lines of business! The reality is this, the fast-food business isn’t that profitable.
Take a look at McDonald’s three sources of revenue:
The consolidated income statement shows three revenue sources. The first are sales by company-operated stores. There are 40,031 McDonald’s restaurants worldwide. Of these, 2,736 are company owned and operated. That $9.8 Billion represents the sales at full menu price at these 2,736 locations.
The third line of $350 Million represents technology fees charged to franchisees and sales from non-restaurant products. For example, if you go to the grocery store and buy McDonald’s ground coffee for your home consumption, that sale is what is recorded in that line. Overall, this line is insignificant and is not one of the three distinct business lines for McDonalds.
Revenues from franchised restaurants are actually two distinct sets of sales. Look at this breakout for sales from franchised restaurants:
Everyone is aware that franchisees pay a 4% fee to McDonald’s to use their name and sell their products. Thus, unlike company owned stores, when a sale is processed, the sale is recorded on that franchisee’s income statement and then they in-turn pay a royalty to McDonald’s at the corporate level. This royalty is what is recorded as the mother company’s revenue. Thus, in reality, total worldwide sales of products in the aggregate is not $23 Billion as stated above, total sales actually exceed $110 Billion. McDonald’s at the corporate level is recording $9.8 Billion from their company operated stores and another $4.6 Billion for royalties from the other 37,295 locations. Why is this so important?
Notice that so far, there are two distinct lines of revenue; first corporate level sales, then royalties. Thus, of the $23.2 Billion in sales, $14.4 Billion is directly related to the sale of food.
Look at the top line of sales from franchised restaurants. Notice that it states rents? This is the third line of business for McDonald’s. McDonald’s earns 36% of its revenue as a landlord!
McDonald’s is a franchising business and this franchising is fully inclusive. Not only are they charging for the use of the name, they charge many of their franchisees for the land/building the franchisee is operating from. McDonalds is more a real estate company than it is a franchisor.
This is critically important when determining intrinsic value. Real estate model formulas are dramatically different than other intrinsic value formulas. To explain this, one must understand the profitability related to each of these three distinct revenue streams. From evaluating the financial statements, the author has determined that these are the contribution margins for each of the respective three revenue streams:
*In Millions
Distinct Revenue Stream Corporate Operated Restaurants Royalties Real Estate
Revenue $9,787.4 $4,645.1 $8,381.1
Costs 8,047.3 260.4 2,335.0
Margin $1,740.1 $4,384.7 $6,046.1
. 17.78% 94.39% 72.14%
The key is the volume of absolute dollars the real estate arm injects into the company’s overall gross profit margin. Assuming all overhead expenses are equally allocated, then real estate is just slightly more than 50% of the total net profit McDonald’s generates each year. This means McDonalds is a real estate company first, then a franchisor then it runs fast-food restaurants.
To validate this business model, look at McDonald’s balance sheet, specifically the tangible assets section.
Tangible assets equals $38.3 Billion (the two highlighted lines added together). Of the $38.3 Billion, lease rights are 35% of tangible assets. In addition, within the property and equipment line, about $13.3 Billon of that value is for improvements on leased land. Thus, in the aggregate, $26.8 Billion of the $38.3 Billion is associated with the real estate arm of McDonald’s. In the aggregate, about 50% of McDonald’s total assets are directly tied to the real estate function.
What McDonalds is doing is acting as a real estate broker. They seek out prime spots in good locations and proceed to acquire long-term rights via leases to this property. Then, they infuse some capital to develop the site including access/egress, utilities, zoning and in some cases site preparation (clearing, drainage, curbs, sewage lines, etc.). Once the site is fully ready, a franchisee is approached to sub-lease the site from McDonalds and build a restaurant.
Basically, the rent charged is about four times the amortizable cost associated with that site. It is a very powerful model for real estate management. What is really outstanding is this: it locks in revenue for a sum certain period of time (at least 20 years). Locking in revenue streams is one of the key characteristics of stability. Stability is the number one determinant of risk. The more stable a company, the less risk involved which in turn reduces the discount rate.
It is this discount rate that is used in multiple versions of the intrinsic value calculation.
Intrinsic Value – Setting the Discount Rate
A discount rate is really a cost of money factor. It is mostly used to determine a current value of a set of future inputs. A simple way to think of a discount rate is to envision it as a cost of money due to inflation. Thus, future receipts of cash are not worth as much as a current receipt is at this moment. Intuitively, we know that $100 today is worth $100; but, a $100 receipt 10 years from now is not worth $100 today. There will be inflation in the interim. Thus, that $100 receipt might only be worth $70 today.
In addition to inflation, there are other factors to consider, most of these other factors play a greater role than traditional inflation and will force the discount factor higher. Other factors include:
- What kind of return does the receiver of money want for their investment? In this case, a shareholder is willing to pay a certain sum in order to hold a share of stock in McDonald’s. Thus, how much of a return does an equity position owner desire and what is fair?
- How easy is it to dispose of the investment? The more difficult it is to sell your equity position, the higher the risk and as such the discount rate must go up too. For example, for those that own small businesses, how difficult and time consuming is it to sell your ownership in a small business in comparison to selling stock with a DOW level equity position? With McDonald’s, there are always willing buyers for this company; therefore, there is very little risk that this will be an issue seven or ten years from now.
- What is the risk tied to the industry this company operates within? Remember, from above, McDonald’s is more of a real estate broker than a fast-food operation. Fast-Food operations are at a greater risk than real estate brokers. When determining this risk element in the discount rate formula, McDonald’s discount amount will be much less than Shake Shack’s because Shake Shack is not a franchisor (they have 11 out of the 360 locations which in the overall scheme of things means they have no franchisees). Both McDonald’s and Shake Shack are in the Informal-Eating-Out industry, yet one’s discount rate tied to this risk component is significantly lower than the other party.
- Size factor also affects the discount rate. The larger the organization and the more geographically spread out, the lower the overall risk associated with this element of computing the discount rate. In effect, economy of scale has a dramatic impact on risk reduction.
There is a five part formula to setting discount rates for every entity. The following walks the investor through the five steps.
Step I – Perfectly Safe Investment Yield
Use the core government bond yield to acknowledge the discount for a perfectly safe investment. This should match the closest time frame related to the time frame for the discount application for the respective investment. In this step, a long-term yield is desired. The current 30 year no risk yield is 2.46%.
Step II – Additional Yield for a Pure Equity Position
The next layer of discount reflects what a reasonable individual would desire for a pure dividend yield for their investment. A respectable amount is around 2.75%. Anything less than 2.4% is unreasonable for high quality investments and anything greater than 2.9% is unusual although sought after.
Step III – Risk Factor to Dispose
In the overall scheme of security investments, stocks are typically the most risky group. Thus, a risk premium is applicable. The more market capitalization involved, the less of a risk factor exists. McDonalds is a DOW Jones Industrial Average stock and as such, DOW members are considered the least riskiest of all stock securities. Here, only a .25% additional discount is necessary to adjust for this position within the market.
Step IV – Industry Risk Factor
The informal-eating-out industry has had an interesting history related to its risk element. In an unusual display of resilience, right after the recession started in 2008, for some reason fast-food restaurants experienced a surge in sales. The thinking is that fast-food substituted for sit-down restaurant style eating. In effect, people shifted their eating out habits but continued to eat out. Still, this industry is highly susceptible to unusual and infrequent circumstances. COVID proved this and of course supply chain issues do exist. Thus, the risk factor here is much higher than disposal risk. For McDonalds, this risk factor is around 1.25%.
Step V – Economy of Scale
Just recently, the Russian-Ukranian War demonstrates the exposure McDonalds has to international locations. McDonalds has pretty much lost the revenue and profitability related to the almost 1,000 corporate owned locations in Russia and in Ukraine. Although the locations in Ukraine will revive in several years, the locations in Russia are closed permanently due to the world wide economic exclusion of Russia.
This is a big hit to revenue tied to these locations; however, it will not impact the bottom line significantly. The reason is due to the profitability of corporate owned locations (see Business Model above). The net maximum impact for those stores may be around $250 Million per year on the bottom line. With a net profit in 2021 of $7.5 Billion; the loss of Russian locations will impact future profits a negative 3.1% for the foreseeable future. This is an example of the impact (risk factor) tied to the company level. Naturally, the larger and more geographical diverse the company, the less risk involved. The war is an example of unique circumstances and highly unusual. But this just further solidifies the need to be geographical dispersed as much as possible in order to minimize the impact of unusual events. Given the situation, McDonalds is still geographical spread out and as such, a risk discount value of .5% is appropriate for economy of scale. Remember, McDonalds still has over 39,000 restaurants remaining worldwide. For comparison purposes, only Starbucks comes close with almost 34,000 locations. Wendy’s has around 6,800 restaurants; Chipotle has around 3,000 stores. Thus, McDonald’s is in the best overall position for economy of scale.
Combined Discount Rate
To sum up the discount rate, add all the respective values together:
- Step I – Perfectly Safe Investment 2.5%
- Step II – Desired Dividend Yield 2.75%
- Step III – Disposal Risk .25%
- Step IV – Industry Risk 1.25%
- Step V – Economy of Scale .5%
Cumulative Discount Risk Factor 7.25%
There are some general guidelines related to the overall setting of discount rates for investing purposes. First, expect the range to be as low as 7% to as high as 13% for value investment related securities. Securities that are in the penny stock to small cap range will have discount rates much higher than 13%. At the other end of the spectrum are the DOW Jones Industrial Companies. They will range from 7% to as high as 9% depending on their management team, production performance and their overall stability. Remember, the more stable and well managed a company, the lower the discount rate. Top end operations such as McDonald’s, Coca-Cola, Apple and Verizon will have discount rates between 7% and 7.5%. The only reason McDonalds didn’t hit the lowest (best) mark of 7% is directly tied to the loss of the restaurants in Russia due to the sanctions placed on that country. It was an acknowledged risk many years ago when this venture was pursued and unfortunately, it will not pan out for McDonalds.
With the discount rate set, an value investor can now proceed to utilize the best formula to evaluate total value for McDonalds.
Intrinsic Value – Appropriate Intrinsic Value Formula
There are about a dozen or so popular intrinsic value formulas. No particular formula fits all situations. When calculating intrinsic value it is best to use several formulas and weight them as to their overall importance given the nature of the company’s business model and financial matrix.
Balance Sheet Formulas
McDonald’s is somewhat unique in that most of the balance sheet intrinsic value formulas will not work. This is due to the negative equity position the company carries. A dividend yield of 2.75% would generate an intrinsic value of around $201; a desired yield of 2.5% would set intrinsic value at $222. Given the nature of this company with its well run operation, a dividends based investor would want something around 2.9% as the dividend yield, thus the buy price would be around $191 per share. Therefore, the dividend yield thinking would bring a value range of $191 to $222.
Since balance sheet based formulas are impractical, other types of formulas are better alternatives. Initial thinking is to use cash flow as the basis of determining intrinsic value.
Cash Flow Formulas
Discounting cash flow is the most common intrinsic value formula used. The reasoning is based on the theory that ownership of an asset (in this case a security) is worth all the future cash inflows discounted to a current value. However, this particular financial formula is designed to assess whether the price of a producing asset is worth the expenditure today. The future cash inflows are discounted based on a desired rate, typically the cost of capital for the company. With the traditional application, cash inflows are relatively accurate and reliable.
When using the formula at the equity level of investment, the user must qualify the formula for several underlying elements plus the fact that not 100% of all inflows will purely benefit equity stakeholders. As stated, the discounted cash flows method assumes future cash inflows are accurate and reliable.
Underlying elements include accrual adjustments, costs to maintain the balance sheet fixed assets and other types of cash flows statement adjustments. Very few people are trained in how the cash flows statement works. Even among CPA’s that are formally educated in calculating cash flows, only a small percentage truly understand the complexity. Thus, these so-called experts that just arbitrarily use cash flows or even free cash flows to determine value don’t adjust cash flows for all these accrual and other timing differences. The results can be woefully inaccurate. This is just the beginning of how inappropriate it is to simply default to this formula. There is more.
The second flaw with this method is several fold. First, it assumes that all future cash inflow will be used to 100% benefit the asset owner. The reality is far different. For those companies that pay strong percentages of their earnings as dividends, the discounted cash flows method may have better merit. But most companies allocate their cash inflow to purchasing opportunities or maintaining the productive assets or simply improving the balance sheet by reducing debt or adding cash to the asset side of the balance sheet. Rarely if ever is there a true 100% benefit to the equity holders. Secondly, the discounted cash flows method must be qualified for terminal value. Terminal value is quite complicated and is only applicable with operations that utilize long-term assets that generally appreciate in value over time. This includes real estate, certain territorial rights, licensing privileges and certain synergetic portfolios (think of railroads, utilities, metro systems and airports).
McDonald’s doesn’t really qualify for using the discounted cash flows method to determine intrinsic value. Let’s be clear here, most of the franchising arrangements along with those lease contracts have definitive ending dates. Therefore, there is no continuation use of those assets. Granted, McDonald’s can resell the franchise rights etc.; but, they must renegotiate land lease rights at some point in the future. In addition, if you review the cash flows statement, you will discover that if you were to adjust for accruals and other timing differences and then adjust for capital expenditures you will discover that real cash flows for the purpose of utilizing the discounted cash flows method is actually LESS THAN earnings on average. As such, using the discounted cash flows method to determine intrinsic value for McDonald’s is a mistake; an error that increases risk for a value investor.
Discounted Earnings Formulas
The best method of determining intrinsic value for McDonald’s is to use one of the variant versions of discounted earnings. There are several variations of this model.
One of the original tools used is the old core model advocated by Benjamin Graham and David Dodd. Their formula is grounded in earnings and a basic growth rate. Their formula is:
Value equals Earnings times ((a factor of 8.5 plus (2 times growth rate));
McDonald’s Intrinsic Value = Earnings X ((8.5 + (2XGrowth));
McDonald’s Intrinsic Value = $10.04 X ((8.5 + (2X3.5)); Assumes a growth rate of 3.5% per year;
McDonald’s Intrinsic Value = $10.04 X 15.5;
McDonald’s Intrinsic Value = $156 per share
The question here is, ‘What is McDonald’s Growth Rate?’ For now, let’s leave this at 3.5% per year. This element of the intrinsic value is explained in much deeper context further below in this section.
A second and more common version of the discounted earnings method is to average the comprehensive income over the last five years weighting the respective years. Since COVID is an unusual and infrequent event, it is wise to fully disregard 2020 in the formula. Using a weighted factor of 50% for 2021 and 25% for 2019 and so forth for five full years, the average annual earnings are as follows:
Year Comprehensive Income Weighted % Effective Income
2021 $7,558 Million 50% $3,779 Million
2019 6,152 Million 25% 1,538 Million
2018 5,493 Million 15% 824 Million
2017 6,109 Million 5% 305 Million
2016 4,473 Million 5% 224 Million
Average $6,670 Million
Using this average annual income discounted at 7.25% with a growth rate of 3.5%, the cumulative intrinsic value for McDonald’s equals $139,756,000,000. With 744.8 Million shares trading in the market, each share is worth approximately $187.64. Again, the key is IF the growth rate is 3.5%.
With a stronger growth rate, the value will increase dramatically. To illustrate, if McDonald’s growth rate is 4%, each share is now worth $202.90. At at 3% growth rate, McDonald’s share value drops to $174. Thus, the growth rate does play a dramatic role in determining McDonald’s value. So what is McDonald’s growth rate?
McDonald’s Growth Rate
Before delving into McDonald’s growth rate, there are some general guidelines related to growth, specifically the growth rate during the life cycle of a company. The best descriptive comparative is that with good companies, their growth rate mimics human beings. Growth starts out slowly and it takes four to five years to gain momentum. During those teenage years, companies experience massive growth and then there is maturity and aging. Thus, as a company heads towards greater stability and maturity, annual growth rates decrease. Thus, value investors should expect to see around three to five percent growth per year for fully mature companies.
Overall, the economy is expanding at two to three percent per year. In addition, each industry experiences growth too. For these two functions, the growth rate is actually incorporated into the discount rate. As stated in the second section above, take note of the rules/guidelines tied to both economic and industry related risk factors and their impact on the discount rate. What investors are interested in is the growth rate of the company itself. This can be measured in several different ways. With fast-food, you could determine growth based on the number of restaurants or adjust the financial revenue growth by economic growth to determine financial growth. With some industries, growth rates can be determined by the expansion of the primary assets that generate real value.
Remember from above, what is McDonald’s business model? The core profit generator is the real estate arm of operations. To determine this aspect of business growth, compare rent revenues generated 11 years ago to revenue generated this past year.
2010 $5,198 Million
2021 $8,381 Million
This means, that over course of 11 years, total rent receipts increased $3,183 Million or about 4.4% per year on average. This 4.4% growth rate is not the growth rate value to use. However, it does impact the overall growth rate the most. The second growth rate asset for McDonalds is the number of franchisees and their growth rate over the same time period. In 2010, there were 29,420 franchisees. At the end of 2021, 11 years later, the are 37,295 franchised restaurants. This is an annual growth rate of 2.2%. From the business model above, the real estate arm provides 50% of the profit margin and franchising provides another 36% of the profit margin. In relation to each other, the real estate aspect of operations is 58% of the value of growth and therefore contributes 2.56% growth. Franchising is 43% of the value of growth and thus, it contributes about .95% of the total growth of McDonald’s. Adding the two items together, it is fair to say the McDonald’s is growing at around 3.51% per year. Most likely, it is just slightly higher due to the other revenue streams (corporate restaurants and other income).
Using a 3.6% growth rate is a reasonable and fair growth rate for the purpose of future revenues.
The final outcome is this:
Using a 7.25% discount rate and a 3.6% growth rate over a 40 year period, with a starting point of $6.67 Billion comprehensive income, total market value of McDonald’s is approximately $141,927,900,000. With 744,800,000 shares in the market, each share’s intrinsic value is estimated at around $190.56.
No other intrinsic value formula will get this value as accurately stated as the discounted earnings method with an appropriate growth rate. The question is now, does this and is this a reasonable and fair assessment of McDonald’s intrinsic value?
Intrinsic Value – Objective Testing
A solid business ratio that provides good insight and objective results is the market price to earnings ratio. The ratio does have flaws and the key is to properly apply the ratio to minimize or negate these inherent flaws. One of the inherent flaws with this ratio is that it is often used as an instant ratio, i.e. what is the current market price to earnings at this moment. The issue here is of course earnings. Earnings fluctuate from quarter to quarter and from year to year. Averaging these earnings eliminates this inherent flaw. With this ratio, it is applied in reverse; here a value investor seeks intrinsic value price based on earnings. Each industry has a range (a multiplier) of earnings to determine intrinsic value. The stronger performers in this industry have higher intrinsic values per dollar of earnings. As an example, Shake Shack has hardly earned any money since inception twenty years ago. Its intrinsic value price to earnings is less than 10:1. Wendy’s earns less than 90 cents per share. Its multiplier is just a mere 12; this sets Wendy’s intrinsic value to less than $10 per share.
From above, McDonald’s average earnings per share are $8.96 per year. The fast-food industry’s price to earnings ratio range is broader than other industries. This is due to the higher than normal reliance on consumer discretionary income used to make those marginal purchases of meals. Thus, low price to earnings of 12 to 14:1 ratios are representative of buy ranges for fast-food securities and intrinsic value ranges are 16 to 18:1 range. Since McDonald’s is the standard bearer for the fast-food industry, intrinsic value should and is at the top end of this range. Thus, having an 18:1 or even upwards of a 20:1 intrinsic value price to earnings ratio representing intrinsic value is reasonable. At 20:1, intrinsic value is approximately $179 per share.
From above, intrinsic value is estimated at $191 per share or a 21.3 to 1 price to earnings ratio. Thus, the outcome based on discounted earnings is slightly higher than an anticipated price to earnings ratio. Using the most recent year of $10.04 per share of earnings, at 19:1, the price to earnings ratio estimates intrinsic value at $191 per share. Again, only McDonald’s warrants this high price to earnings ratio as it is not only the standard bearer within this industry, it outperformed all other similar companies. Thus, only McDonalds commands such a high price to earnings ratio as an objective test to validate intrinsic value calculated using the discounted earnings method.
A second objective test looks at McDonald’s as no different than a pure flip investment, similar to how house flippers look at their opportunities. House flippers take the current market value for a comparable asset and in turn they are willing to spend about 60 cents on the dollar to buy a distressed property and renovate the property. The idea is invest 60 cents on the dollar and placed the asset back in the market and sell it at the expected market price. With securities, this means a value investor would look at the most recent peak market price and would want to buy this asset at 60 cents on the dollar.
With value investing, the buy price is customarily five to as much as twenty-five percent discounted from intrinsic value. The more secure and stable the particular investment, the lower the discount applied against intrinsic value. With McDonald’s, a seven percent discount to intrinsic value is appropriate. First, the company is quite stable and it is also well managed. Thus, there is limited to no risk involved with buying at seven percent discount against intrinsic value. This means, with an intrinsic value of $191 per share, a good buy price for a value investor is $178 (7% discount against $191).
This buy price of $178 is then the basis for the 60 cents on the dollar concept. In effect, what is the market price for a security that one is willing to buy at 60 cents on the dollar if that equals $178. The answer is that the market price should have been or is currently near $297 per share. Looking back at McDonald’s market price for the last three years, the highest selling price was $271 per share back in late December 2021, early January 2022. At 60 cents on the dollar then, the buy price would be approximately $163 per share, and if this is a 7% discount to intrinsic value, intrinsic value would approximate $175 per share.
It would appear that the calculated intrinsic value of $191 per share is about nine to 10% too high.
McDonald’s Intrinsic Value – $184 Per Share
These two objective tests seem to indicate that $191 per share as intrinsic value is strong. For those of you that are not regular members of this site’s course of study in value investing, it is stated multiple times and is taught that intrinsic value is a range supported by more than one formula.
Based on the results with desired dividend yield, discounted earnings using a reasonable growth rate and the objective tests, it would appear that intrinsic value at $191 per share is at the higher end of the intrinsic value range. Thus, intrinsic value is most likely three to four percent lower than $191. Even though the dividend yield range was determined to be between $191 and $222 per share, it is apparent that McDonald’s greater than 50% dividend payout from earnings is not enough to justify buying this stock at $191 per share.
The end result is this, two objective tests indicate that an intrinsic value of $191 is too strong. Dividend yield at 2.9% results in a valuation of $191 per share too. Thus, investors are indicating that with such a high performing company like this, dividend yields should be even higher (3.1% to 3.3% range) lowering the intrinsic value slightly.
Based on all the above, McDonald’s intrinsic value is $184 per share. A buy price is set at a 7% discount to this intrinsic value; therefore, it is recommended that value investors buy McDonald’s stock at $171 per share.
As noted throughout the Value Investment Fund articles, posts and decision matrixes, the Fund takes a conservative position overall with estimating intrinsic value. Although $191 per share is justifiable, conservative thinking demands a more prudent valuation and as such, this site’s Value Investment Fund Fast-Food Industry Pool will use $184 as intrinsic value as of April 2022. In addition, this intrinsic value increases at $2 per share per quarter and is this Value Investment Fund’s buy/sell model for McDonald’s for the next two years. Thus, once the quarterly report is issued in late April, the intrinsic value will increase to $186 per share and the corresponding buy price will increase to $173 per share.
A reasonable and fair selling price for this stock is $235 per share. Act on Knowledge.
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“To inspire and nurture the human spirit – one person, one cup, and one neighborhood at a time.” – Starbucks’ Mission Statement
What would you pay for a stock that has the following negative attributes?
- A book value of MINUS $7.33 per share (yes, you read that correctly, a negative book value);
- A recorded deferred liability to Nestle Corporation for almost $6.6 Billion;
- Recorded a decrease in the company’s already negative equity position another 60%, i.e. $3.1 Billion more during the most recent quarter (1st qrt of 2022);
- Has 5,358 locations in China which is 31% of its corporate owned stores (think of risk exposure if there is a military altercation between the US and China);
- Spent $3.5 Billion to buy back 3.1 Million shares when the price of its stock was at or near its historical high market value (1st qrt of 2022);
- Has long-term debt and leases totaling $23.5 Billion with fixed assets of only $15.2 Billion.
Yet, with all these negative factors, Starbucks’ stock price is currently in the mid 90’s range and was selling at an all-time high of $126 per share back in the middle of the summer 2021. Mind you, the company’s stock price was a mere $5 per share just 13 years ago. If you exclude 2020’s financial results due to COVID-19 and average the last 3.25 years (2018, 2019, 2021 and the 1st quarter of 2022) you get an average annual earnings of $4,040.8 Million ($4.04 Billion). Using Graham & Dodd’s core formula to calculate value and assuming a 6% growth rate, total market value equals:
Average Earnings X ((8.5 plus (2 Times Average Expected Growth Rate)) = Market Value
$4,040.8 Million X (8.5 plus 12) = Market Value
$4, 040.8 Million X 20.5 = Market Value
Market Value = $82,836 Million ($83 Billion)
With 1,176.6 Million (1.2 Billion) shares in the market, each share is worth about $70 each. At a more realistic 4.5% growth rate, each share is worth about $60. Even using the best quarterly results in the last four years and extrapolating this as the average quarterly amount for an entire year, average earnings per year would equal $5.93 Billion and with an average annual growth rate of 5.5%, the market value would approximate $115.6 Billion or about $98 per share.
Thus, assuming some strong liberal values, at most, Starbucks (under Graham & Dodd’s core formula) is worth $98 per share. With more conservative elements of the formula, Starbucks is worth around $60 per share. Graham and Dodd’s formula was developed over 70 years ago and prior to the stringent reporting requirements that exist today. Intrinsic value calculation has matured dramatically since then. In addition, the underlying tools to measure average earnings, growth rates and the base multiplier have also made significant advancements since the 1960’s. Thus, this article will illustrate that the actual intrinsic value is less than $50 per share; and, this is using reasonable estimates for the elements of several different intrinsic value formulas. If a value investor were to use more conservative estimates, the intrinsic value drops below $40 per share. As a buyer of stock, understanding intrinsic value of any investment is essential to make good decisions and build a reliable buy/sell matrix for any investment.
As with all intrinsic value formulas, the value investor must first grasp the overall business and financial model of Starbucks before proceeding to document outcomes.
Starbucks’ Intrinsic Value – Business and Financial Model
Starbucks’ business model almost mimics the fast-food industry model. Starbucks’ has approximately 17,150 corporate owned stores. In addition, it has 16,700 licensed stores. Licensing is very similar to franchising; its really more legalize than anything else. Basically, Starbucks charges for the products sold and an additional royalty of around 7% on gross receipts. Thus, Starbucks income per dollar of sales from their licensees is much stronger than other fast-food restaurant chains. From the Fast-Food Pool page on this website, Starbucks is considered one of the members of the informal eating-out industry; which most folks call fast-food. Starbucks does have a third segment of income called Channel Development. This segment reflects sales of products through a master arrangement with Nestle. Thus, when you go to the grocery store and buy a bag of Starbucks coffee to brew at home, that sale is recorded in this segment of the company’s sales. It is a very minor segment in comparison to the to two primary segments of sales – corporate owned and licensed receipts.
Of all the fast-food members, Starbucks is by far the most international of them, far superior to even McDonalds. Of the 33,900 stores worldwide, 17,000 are considered international. Those in Mexico and Canada are considered in the North American group with 15,444 stores in the United States. Thus, Starbucks is truly reliant on foreign operations to elevate its status as a powerhouse company.
The financial model matches the business model. There are basically three sources of sales: corporate, licensed fees and channel development. Corporate represents all sales at all corporate owned locations. Whereas licensed sales only represents net receipts for products sold and royalties received tied to the licenses. It does not represent all the sales at the licensed locations. Channel development runs the standard sales and its cost of sales are located in the costs of goods sold section of the income statement. Here is a snapshot of Starbucks’ sales from the past three fiscal years (Starbucks runs a 52-53 week year).
You can see the detrimental impact of COVID-19 in the year ending September 27, 2020 as the impact started in late February 2020.
Thus, 17,150 corporate owned stores generated $24.6 Billion in sales or about $1,435,000 per store per year. In comparison to the traditional fast-food restaurant, Starbucks sales on a per store basis doesn’t even come close. A typical McDonalds is in the $3 Million range, Wendy’s is in the $1.8 Million range. Thus, it is critical for the gross profit margin to be higher in order to generate enough absolute dollars of profit to offset the store’s operating expenses. And Starbucks does indeed do this. Their typical operating margins are in the 15 to 18% range which is superior to all other fast-food operations. HOWEVER, Starbucks costs of capital, e.g. all that debt Starbucks carries eats into the higher than others’ margin. In 2021, Starbucks paid almost $470 Million in interest and is on track to pay almost the same in 2022. This interest cost dampens results dramatically and greatly affects how value investors approach calculating intrinsic value.
Here are the net profits for the last four years excluding fiscal year ending 2020 due to the impact of COVID. This excludes other comprehensive adjusting items (mostly international money exchange earnings due to the strong international market position and the power of the American dollar over other monetary systems).
2021 $4,199.3 Million
2019 $3,599.2 Million
2018 $4,518.3 Million
2017 $2,884.7 Million
The average, again excluding COVID related impact for the year 2020 is $3,800.4 Million ($3.8 Billion) per year. Average net revenue during this same time period was $25,668.9 Million ($25.7 Billion/Yr). This means the bottom line profit for Starbucks is about 14.8% which falls well short of McDonalds nearly 24% per year. Even adjusting McDonalds to exclude the real estate segment of its profits, McDonalds’ bottom line percentage is well over 20% for its corporate owned and franchise operations.
Overall, Starbucks has more revenue than McDonalds (McDonalds has less than 4,000 corporate owned locations while Starbucks has over 17,000 corporate owned locations) and its model has a stronger royalty fee structure to boot. Yet, its overall profitability is dramatically lower than McDonalds. This is a reflection of the higher per dollar of revenue costs to administer this company. This too affects intrinsic value formulas.
There are three major groupings of intrinsic value formulas. The first group focuses on the balance sheet.
Starbucks’ Intrinsic Value Using the Balance Sheet Elements
Intrinsic value formulas tied to the balance sheet rely greatly on several essential financial statement elements and certain business characteristics. The most important business characteristic is that the company has a strong portfolio of fixed assets that in general retain their cost value or the respective fair market value improves over time. Examples of companies with these characteristics include REITs, utilities, some manufacturing and distributors. Starbucks does not have this business model. It relies heavily on leases and intangible items such as its brand. Thus, utilizing any adjustment for fair market value to balance sheet assets for intrinsic value is meritless.
Even without a step up of assets to fair market value, there are other intrinsic value balance sheet based formulas. Another is book value. The problem with this formula is that the equity section of the balance sheet must have some positive value; Starbucks has a negative equity position. Look at this snippet from the January 2, 2022 SEC filing of the equity section of the balance sheet for Starbucks.
On January 2, 2022 (a little over a month ago at the creation of this article) Starbucks equity position was a negative $8.45 Billion. For many value investors, this is a huge RED FLAG.
This eliminates the ability to use a very popular balance sheet intrinsic value formula, book value. The result will be a negative $7.33 per share.
A third balance sheet intrinsic value ties to the dividend. It is commonly referred to as the dividend yield. This is more effective with strong dividend based operations (think of Coke, REITs, energy providers and McDonalds). Starbucks pays about 45 cents on the dollar of its earnings which is generally higher than most large cap companies but dramatically lower than the standard bearer, McDonalds, in this industry. The current dividend yield is 2.1% which is not strong enough for a value investor. With an equity return requirement of no less than 5%, a $1.96 dividend payout per year is worth around $40 per share. And 5% includes limited risk exposure; with risk exposure, the desired return would have to be in the 7% range’ Thus, at $1.96 dividend payout per year and a desired 7% return, a value investor would determine intrinsic value to be around $28 per share.
Overall, with Starbucks, balance sheet based intrinsic values are not viable to determine intrinsic value. A value investor needs to turn to the income statement based formulas for an idea of value.
Starbucks’ Intrinsic Value Using Income Statement Elements
When looking at any company and determining intrinsic value, certain intrinsic value formulas are more reliable than others depending on the company’s financial and industry model. There is no single universal intrinsic value formula that is superior. Every company has certain attributes that eliminate many of the intrinsic value formulas; thus, through attrition the best formula remains. For Starbucks, the balance sheet formulas are inferior because the simple truth is that Starbucks is upside down; its assets are dramatically less in value than the liabilities recorded. To put it in layman business terms, the company is technically bankrupt (scholastic definition); there is no way it could pay its creditors if it closed up shop tomorrow. A third batch of intrinsic formulas focus on the cash flow (discussed below). For brevity, none of the cash flow intrinsic value formulas are applicable to Starbucks situation either. Starbucks cash flow from operations is positive, but once you factor in free cash flow adjustments and the current liabilities increase, Starbucks cash flow isn’t really superior to earnings. Thus, only the second group of intrinsic values, income statement based intrinsic value formulas, often referred to as earnings based intrinsic value formulas, will provide a realistic idea of Starbucks overall market value.
There are three critical pieces of information required in order to evaluate the overall power of earnings related to any entity. The first piece is of course the company’s average earnings. The second part is commonly referred to as the discount rate, i.e. what is the risk factor associated with this company. The third and final element of the formula is the growth rate. All three elements impact the outcome of the result. The following subsections outline each of the three results.
Average Earnings
Defining average earnings is done in two different modes. The first and most common mode is as an absolute dollar value. This method is pretty straight forward, look back a few years at net profit and then average this dollar amount to derive an absolute value. From above, looking back over four years and eliminating 2020’s result due to COVID, Starbucks average earnings per year was $3.8 Billion. Many analysts have difficulty with using this because the further back one looks the more likely the net profit was lower and it weighs down the overall average. Thus, some analysts prefer to give more credibility to more recent earnings over earnings historically aged. Thus, if a value investor gives more credence to the more recent years over those further back in time, it should improve the average absolute dollar earnings per year. Using a basic sum of the years digits method (an accounting method that places greater emphasis on value to more recent or near future amounts over those further away in time), and looking back four years, the sum of the digits are 4 plus 3 plus 2 plus 1. Thus, the most recent year is worth 4 parts of the total sum of digits of 10. Therefore, 2021’s results are worth 4/10th’s, 2019 is worth 3/10th’s, 2018 is worth 2/10th’s and 2018 is worth 1/10th of the total. The outcome is as follows:
Year Net Profit Multiplier Weighted Portion
2021 $4,199.3 Million 40% $1,679,720,000
2019 $3,599.2 Million 30% 1,079,760,000
2018 $4,518.3 Million 20% 903,660,000
2017 $2,884.7 Million 10% 288,470,000
Totals $15,201.5 Million 100% $3,138,610,000
In general, weighting more recent results will make the outcome higher than the overall average. In this case, weighting more recent activity REDUCES the overall average annual earnings to $3.138 Billion per year from the average of $3.8 Billion. The detrimental earnings in 2019 (recall, COVID affected the entire economy starting in February 2020) greatly affected the method’s final result. In effect, because Starbucks lacks true consistency with its earnings, and it is not consistently improving from one year to the next, the overall average isn’t as reliable as the basis with an intrinsic value formula. A user of a formula should be cautious and give greater reliance on a more realistic average absolute net profit in dollars. In this case, the most likely absolute value is somewhere between the $3.138 Billion and the average of $3.8 Billion.
The second method is net profit as a percentage of sales. This method is easily derived by looking at the cumulative history of sales over a longer period of time, such as 10 years along with total profit from 10 years and calculating an average. This average percentage is then applied against the most recent quarter and then extrapolated for an entire year to determine the most likely profit in the current fiscal year.
During the last 10 years, Starbucks total sales (remember sales includes licensee receipts and not their direct gross sales) were $211,263.5 Million ($211.3 Billion). Total profits during this same time period equals $23,781 Million ($23.8 Billion). Thus, on average, Starbucks net profit margin is 11.25%. Using the most recent quarter ending January 2, 2022 as the starting point, sales were $8,050 Million. Extrapolating for the entire year it equals $32,200 Million in sales for 2023. At 11.25% average net profit, Starbucks will earn about $3,622,500,000 ($3.6 Billion). Just to illustrate Starbucks’ poor performance, sales during this past quarter ending January 2, 2022 were $8,050 Million and net profit was only $816 Million; that’s a 10.13% net profit margin and the 11.25% was the expected amount. Thus, Starbucks didn’t even match the historical average; it fell short by $89.6 Million.
For the purposes of the intrinsic value formula, a conservative earnings value is $3,138 Million, a reasonable expectation is $3,623 Million and for a more liberal outcome, earnings is $3,800 Million. These are the values for this element of the formula used further below.
Risk Factor
The risk factor is the second element in the intrinsic value formula for earnings. This formula uses the standard discounted earnings financial function whereby earnings are discounted based on a risk factor over an extended period of time (25 to 30 years) and summed to a cumulative total current value. For those of you unfamiliar with this basic banking formula, the further out in time earnings is discounted, the more dramatically less is the outcome than the current year’s earnings. Simply stated, the value of one dollar is worth a lot less today the further out one receives that dollar; in effect, inflation and opportunity affect its value. In addition, the stronger the discount rate, the greater reduction in value is applied against that dollar over time.
There are four key parts of determining risk factor. They are as follows:
- Risk-Free Rate – This is the rate that exists with treasury notes. It is what most investors will accept without any risk.
- Equity Risk Rate – A rate an investor is willing to accept given the position they fall within the spectrum of ownership rights, i.e. equity positions range from 4% to as high as 7%. Bond holders are in the 3% to 5% range. Secured bond holders have less risk involved and are in the 2.7% to 3.5% range.
- Size Premium – An additional 1% to 4% depending on the size of the company. For example, Walmart’s size premium is around 1%. Mid-Cap investments are in the 2% to 3% range whereas penny stocks are slightly more than 4% premium.
- Specific Risk – A factor associated with the purpose of the investment and the ability to sell the respective investments in a timely manner. In this case, Starbucks is stable, and it is easy to dispose of a stock position with Starbucks. A bond position would require a higher specific risk. Overall, specific risk ranges from 0% (McDonalds’ stock position) to as high as 4% for an over-the-counter stock purchase.
For Starbucks, the risk outcomes are as follows:
- The risk-free rate is 2.25%.
- Equity risk for Starbucks is much higher than McDonalds due to the lack of highly stable earnings; if you review its historical earnings, it isn’t considered highly stable and it is heavily reliant on international sales; thus, a 6 to 6.75% risk factor is applicable here. For the purpose of this analysis, 6.5% is used.
- Size Premium – Starbucks is definitely considered a large-cap investment; thus, a 1.25% size factor is warranted.
- Specific Risk – The purpose of this investment isn’t to hold the stock nor reap dividends, the purpose is to sell it high upon market recovery. There can be several reasons Starbucks’ market value will decrease below intrinsic value, most of these reasons are long-term in nature such as lack of supply, international politics, a negative equity position on the balance sheet and many more. Thus, the specific risk is going to be higher than McDonalds at zero. For the purposes of this calculation, a 1.25% specific risk factor is reasonable.
Total discount factor is 11.25% which is typically higher than other companies in the S&P 500 with this level of sales and profitability. As a comparison, McDonalds is less than 8.25%.
Growth Rate
With business, growth is a function of the number of locations and the volume of sales per location. Sales can be further broken down into the growth in the number of items purchased per ticket and of course the growth in sales value per item. Your common novice investor will think that inflation is the number one driver of growth; the reality is starkly different. Growth is mostly driven by the ability to expand into new territories and broaden the product line along with increasing the efficiency of existing locations. Think of how a retail outlet can get more people through the line faster, in effect, faster service.
Starbuck’s growth over the last 13 years has been driven by the number of locations throughout the world. On January 1, 2009 (13 years ago), Starbucks had 16,930 stores. At the end of the most recent fiscal year, Starbucks had grown to 33,850; that is almost double from 13 years ago. This means Starbucks’ growth rate is driven by the 5.5% growth rate in the number of stores. The overall financial growth rate is about 7.1% per year. Thus, about 75% of the growth is driven by expansion and 25% of the financial growth is driven by increased sales per store some of which is a function of inflation.
When determining a growth rate, the key is to determine if the growth rate can be maintained. Is Starbucks’ expansion rate going to remain at 5.5%? Over the last four years, Starbucks has an average expansion rate of 4.3%. Thus, Starbucks’ is beginning to slow down its expansion rate. If expansion is 75% of the average growth rate, then Starbucks’ actual growth rate is approximately 5.75%. This is significantly slower than the 7.1% historical average experienced over the last 13 years. Thus, a growth rate of 5.75% to 6.1% is an acceptable range for Starbucks with the intrinsic value formula.
Intrinsic Value Formula Based on Earnings, Discount Rate and Growth
The discounted earnings approach is exercised across three different models – conservative, reasonable and liberal approaches. The approaches vary using the three different earning levels as identified above. In addition, the discount rate will vary about .25% on either side of the pre-calculated rate of 11.25%. The store’s growth rate varies around the 5.9% point which is considered the reasonable expected level of growth over an extended time period. The outcomes are as follows:
Conservative Approach
Using an average earnings of $3,138 Million per year (the value determined using the sum of the years’ digits method) with a discount rate of 11.5% (.25% stronger than the reasonable determined amount of 11.25%) and a slower growth rate within the range from above of 5.75%, total market value of Starbucks equals $44,001 Million ($44 Billion). This equates to $37.42 per share.
Reasonable Approach
Using $3,623 Million as the average earnings with a discount rate of 11.25% and a growth rate of 5.9%, total market value of future earnings equals $53,024 Million or around $45.09/share.
Liberal Approach
Using $3,800 Million as the starting average for earnings and a lower discount rate of 11% with a slightly stronger growth rate of 6.1%, total market value of future earnings is about $58,402 Million or around $49.67/share.
Under the three different approaches, intrinsic value ranges from a conservative estimate of $38 per share to a liberal estimate of $50 share. A reasonable outcome places the intrinsic value at about $45 per share.
Starbucks’ Intrinsic Value Using Cash Flows Statement Elements
The intrinsic value formula using cash flows as the basis for intrinsic value calculations is predicated on one primary requirement, there must be some form of terminal value tied to existing assets of the entity at the end of a reasonable time period such as 25 or 30 years out. The simple reality is that Starbucks does not qualify for this. Its physical assets will be some warehouses they currently use for distribution purposes. Thus, unlike fixed asset intensive operations, the discounted cash flows method will have a very small value for terminal value and in reality given the negative equity position of this company, it may have to pay money if it terminated in 25 to 30 years. Furthermore, most of its value is tied to one real aspect of business, selling coffee. It only works if it is an ongoing concern, not an entity which requires strong cash outlays each year to maintain its existing assets. The cash outlay each year funds growth with continued expansion of corporate locations.
Therefore, any form of a cash flows intrinsic value method will either end up with a lower outcome than the earnings method above or produce unreliable results.
Intrinsic Value for Value Investing (Summary)
Intrinsic value calculations are heavily reliant on the ability to predict the future based on the past. The more common risks of consumer demand, legal issues, employee development and expansion are reduced or included with the outcome due to reliance on an extended past of information. However, intrinsic value can not take into consideration those risks that are unusual, infrequent or may remotely exist. With many companies, these are not obvious. However, with Starbucks, this does exist. Starbucks even states this in their annual reports. Go to page 11 and 12 from the 2021 Annual Report. It lists certain macroeconomic risks that are important to include when assessing their impact. For the purpose of this article, there are two:
- Starbucks sells ARABICA coffee; for those of you unaware, arabica coffee can only be grown in a very narrow band spanning the globe. It is grown in a hilly or mountainous zone with proper amounts of rainfall, warming and cooling extremes and requires manual labor to harvest the beans. Unlike beef where cattle can be raised just about anywhere, arabica beans have a limited footprint of possible growth area on this planet. As Starbucks puts it:
The availability and prices of coffee beans and other commodities are subject to significant volatility. We purchase, roast and sell high-quality whole bean arabica
coffee beans and related coffee products. The high-quality arabica coffee of the quality we seek tends to trade on a negotiated basis at a premium above the “C”
price. … The supply and price of coffee we purchase can also be affected by multiple factors in the producing countries, such as weather, climate change, water supply
quality and availability throughout the coffee production chain, natural disasters, crop disease and pests, general increase in farm inputs and costs of production,
inventory levels, political and economic conditions and the actions of certain organizations and associations that have historically attempted to influence prices of
green coffee through agreements establishing export quotas or by restricting coffee supplies. Speculative trading in coffee commodities can also influence coffee
prices. For example, drought conditions in Brazil have and, given continued drought conditions, are predicted to continue to impact coffee prices. - Starbucks relies heavily on sales from two countries with opposing views on the world order – the U.S. and China. At some point in the future, there will be some form of a possible military encounter which in turn will cause China to possibly disallow U.S. based investments to continue operations in China. Per Starbucks annual 2021 report:
… especially in our largest markets, including the U.S. and China, labor discord or disruption, geopolitical events, war, terrorism (including incidents
targeting us), political instability, acts of public violence, boycotts, increasing anti-American sentiment in certain markets, hostilities and social unrest and
other health pandemics that lead to avoidance of public places or restrictions on public gatherings such as in our stores.
These two risk factors are not built into the intrinsic value formula and as such should be taken into consideration when developing the buy price for Starbucks. The exposure of these two risks should add a lot of caution for value investors, such that, the margin of safety for Starbucks should exceed 20% of the reasonable intrinsic value formula outcome of $45 per share. For the purposes of this article, the current buy price for Starbucks with this Fund is set at $33 which is a 26.6% discount against the intrinsic value. It is one of the strongest margins of safety that exists in the entire portfolio of potential investments.
Using reasonable elements for the discounted earnings formula as follows:
- A reasonable average earnings per year of $3.6 Billion;
- A discount rate of 11.25% tied to the following negative financial characteristics of Starbucks
- Negative book value,
- Board of Directors poor decision to repurchase shares at high market prices when the company has a negative equity position,
- 5400 stores in China,
- Long-term debt and leases exceed corresponding assets by $8.3 Billion (three years of earnings);
- A growth rate of 5.9%;
Starbucks’ intrinsic value is approximately $45 per share. Any investor should err towards a more cautious approach given all the existing negative characteristics and potential dramatic unusual risk factors this company is exposed to in the world economy. Furthermore, the Board of Directors is not acting wisely when they allow the company to use its cash to the tune of $3.5 Billion to buy back stock at extreme market prices (estimated at over $110/share). Simply stated, Starbucks current market price is so overvalued and at such a high risk of falling quickly to a very low price (like in the teens); it is wise for a value investor to just let that happen and purchase this company at a super low price when it does. Act on Knowledge.
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Provide Food With Integrity – Chipotle Mexican Grill, Inc. Mission Statement
Chipotle Mexican Grill, Inc.’s current (01/24/22) market price is around $1,400 per share, trading as high as $1,930 late last summer (summer of 2021). The market price is hyped up on the strong belief that this company will generate incredible results over the next few years. The truth of the matter is this: even if you took the absolute best quarterly result from the last five years, extrapolated that value as the normal value for Chipotle, then doubled its growth rate, the maximum best value for Chipotle would equal $480 per share. To put this succinctly, the market price for stock is so overpriced that the best term to describe this is ‘irrational exuberance’ (Alan Greenspan, December 5, 1996).
There is no doubt this company produces a great product that is loved by millions of consumers. Even more, Chipotle has grown in leaps and bounds with volume of restaurants over the last ten years (adding 1,300 restaurants in eight years); it currently has 2,900 locations. More importantly, Chipotle’s gross margin has improved to a respectable 11.9%. Add to this, Chipotle has not recorded a loss during the last ten years. However, Chipotle’s financial model does not mirror the fast-food restaurant financial model customarily found with franchised operations such as McDonald’s, Wendy’s, Restaurant Brands International and Dominos. Furthermore, the law of diminishing returns will begin to dampen growth and impact the ability of Chipotle to maintain a high quality meal. In effect, the growth experience that Chipotle has seen can not endure. Instead of seven and eight percent annual growth rates experienced over the last ten years, growth will shrink to a more realistic four and five percent per year.
The growth rate is one of the three most important elements when determining value. Using Graham and Dodd’s famous intrinsic value formula advocated from their life’s work (Security Analysis), value equals average yearly earnings over the last three years times ((8.5 plus (2 times expected growth, as an absolute value, over the next seven years)). This turns out as follows:
VALUE = Average Earnings of $10.57 times ((8.5 + (2X5)), assumes a 5% average growth rate for the next seven years;
VALUE = $10.57 times 18.5;
VALUE = $195.55
In general, Chipotle Mexican Grill, Inc. is worth about $196 per share. Many readers will find this unbelievable given the fact that the market’s current price is over $1,400 per share. How can this dramatic difference exist? This article will answer this and substantiate that indeed the intrinsic value is less than $180 per share. Optimum buy price is around $153 per share which provides a reasonable margin of safety for the investor. Furthermore, it will explore how the market has driven the share price to such an irrational level of value.
To the reader, you have to be realistic about this situation. NO COMPANY THAT EARNS LESS THAN $25 PER SHARE PER YEAR IS WORTH MORE THAN $600 PER SHARE. There are no justifiable characteristics that can substantiate such ludicrous values over $600 per share. Any credible resource, accountant, finance guru, or economist will tell you this. If anyone says otherwise, their educational background and experience should be questioned. The simple truth is that buyers and sellers of this stock are conducting business on speculation and not sound business principles. Do not get caught up in that foolish behavior.
To gain an understanding of intrinsic value for any company, the first step is to gather the core financial elements of the operation; one must understand the company’s financial matrix. Next, using this information, a value investor generates several different value points and compares them against industry models to determine this particular member’s position in the hierarchy of potential investment among this member’s pool. With this knowledge, several different intrinsic value formulas are applied and using a compare/contrast thought process, the value investor can develop a reasonable intrinsic value for this investment. Furthermore, risks are explained and why it is so important to create a margin of safety related to intrinsic value as the buy point for this security.
The final sections will explain how the market has driven this particular stock’s price so high. It finishes with the optimum sale price if the opportunity to buy develops and is exercised. But to get to this point, the value investor must first understand the core financial elements.
Chipotle Mexican Grill, Inc. – Core Financial Elements
With restaurants, an investor must remember the distinct business model (Lesson 19). Informal dining out (fast-food) operations are high volume, low margin models. Rarely does any single transaction exceed $30 as the final sales price. Furthermore, fast-food companies are highly competitive and as such, the consumer is price sensitive too. Thus, any ability to generate operating margins in excess of 16% are unrealistic. The key to financial success is volume. Each store must prepare as many orders as possible and maintain high levels of throughput in order to generate enough gross margin to cover the location’s occupancy and other traditional operating expenses.
Thus, one of the core financial elements is volume; how much are the stores producing in sales and is it growing? For Chipotle Mexican Grill, Inc., look at their sales volume per store for the last seven years:
Sales/Store # of Stores
2014 $2,472,000 1,783
2015 $2,424,000 2,010
2016 $1,868,000 2,250 *Sales drop dramatically due to E. Coli incident.
2017 $1,940,000 2,408
2018 $1,984,000 2,491
2019 $2,205,000 2,622
2020 $2,223,000 2,768
Yes, sales are growing per store and the volume of stores are also growing each year. But there is a catch here; notice how sales per store in 2020 have not reached the same volume of sales as recorded at the peak back in 2014. Though, some good news here, as of the third quarter 2021 and extrapolating into the fourth quarter 2021, sales volume per store has reached a lifetime new peak of $2,554,000.
Thus, there are two distinct growth contribution factors. First, sales per store are improving two to three percent per year with a significant increase in 2021 (which was experienced by the entire fast-food industry across the board). Secondly, the number of stores are increasing five to six percent per year which is the primary reason overall sales are having such an outstanding increase from one period to the next. Overall, better than average industry growth exists for Chipotle. When evaluating growth, the value investor is really interested in a reasonable expectation of growth over the next seven years. Assuming no economic downturns such as a recession and the lifting of all COVID-19 restrictions, it is reasonable to expect a good growth of four to six percent per year for the next seven years. Therefore, any value within this range would be considered Chipotle’s growth rate.
In addition to growth, other financial related values are necessary. One of the critical pieces is the overall operating margin per year. Basically, a value investor wants to know, how much is the company as a whole netting with its income from one year to the next and what is this particular value’s growth rate. Here is Chipotle’s operating income from the last eight years and the expected amount for 2021 given information through the third quarter 2021 extrapolated into the fourth quarter.
. Values are in Thousands
Sales Operating Profit Margin
2014 $3,214,591 $710,800 22.11%
2015 $4,108,269 $763,589 18.59%
2016 $4,501,223 $34,567 7.68% * E. Coli Issue
2017 $4,476,412 $270,794 6.05%
2018 $4,860,626 $258,368 5.32%
2019 $5,561,036 $443,958 7.98%
2020 $5,920,545 $290,164 4.90%
2021 $7,450,173 $886,327 11.89% *Estimated the 4th Qrt Results Based on 3rd Qrt Actuals
Even with a banner year in 2021, operating margin at 11.89% is respectable but not at the standard McDonalds’ has set at 14.23%. This means that if Chipotle could perform at the standard McDonald’s has set, Chipotle’s operating profit would be around $1,059,995,000. After taxes and interest, Chipotle’s bottom line net profit could reach as much as $670,460,000 per year. Thus, with $7.5 Billion in sales, Chipotle could net as much as $700,000,000. This means the bottom line net profit is about 9.3% at optimal operations. This is important because this value is used in one of the intrinsic value formulas.
A third set of financial data important to determine intrinsic value is rooted in the balance sheet. This is a summary presentation of Chipotle Mexican Grill, Inc.’s balance sheet.
One of the interesting data points related to many fast-food restaurants is how lease obligations are always greater than the leased assets. This is not unusual, but it reflects how the lessor typically does site improvements that will go beyond the term of the lease but in effect, gets the tenant to pay for this in the lease negotiations. For Chipotle, leased assets are worth about $2.8 Billion at the end of 2020 and the corresponding lease obligation exceeds $3.1 Billion. This difference is customarily amortized out during the first seven to eleven years of a lease. In effect, Chipotle is paying more each month than what the asset that is booked is worth each month.
As Chipotle builds more restaurants, this long-term obligation will continue to grow.
There is one really glaring value on this summary report. Shareholder’s equity is 33.7% of the assets. This is pretty strong for a company this size. The reason is simple, Chipotle Mexican Grill, Inc. pays no dividends. In its entire history, not once has it issued dividends. This is a very important point when it comes to value investing. Chipotle reinvests every dime it has made which accounts for the huge growth rate it has experienced over the last ten years. Since Chipotle’s business model does not include franchising like most other informal eating out (fast-food) operations, it must retain all earnings to fund the growth of company owned restaurants. Not one restaurant in its entire portfolio is a franchised eating establishment. Just like the net operating income value is used with some intrinsic value formulas, so too does this non-dividend status impact balance sheet based intrinsic value formulas.
Chipotle Mexican Grill, Inc. – Value Points Within Its Industry
The informal eating out industry (fast-food) adheres to a particular financial model for success. McDonald’s is the absolute standard bearer with this model. Simply put, the model has three segments. The first is the traditional corporate owned restaurants segment. In general, McDonalds has over 2,700 corporate owned establishments. This serves a dual purpose, the primary purpose is to act as the model of performance for the second segment, franchisees. Secondly, the corporate owned locations produce a profit. This segment generates an operating margin of more than 14% and once adjusted for interest and taxes, this segment easily contributes at least a 10% net profit in relation to this segment’s revenue.
The second segment is the real money producer for McDonalds as it is for other fast-food chains. Franchising is by far the most important financial segment of any well-run fast-food chain. In general, the corporate office charges a 4% franchise fee on every dollar of revenue the franchisee generates. There are costs to this franchise fee, mostly monitoring, compliance enforcement and general administration of the program. But overall, franchising generates operating margins that often exceed 45% for most corporations. McDonalds has over 36,000 franchised outlets. This single segment is what elevates the overall profit margin as whole for McDonalds. In general, McDonalds net profit is over 22% per year. This segment is the driving force of value for any fast-food chain.
The third segment is really a real estate management operation. The idea is straight forward, the corporate office goes out and finds the ideal sites/locations for future franchisees. The corporate office negotiates long-term leases for this land and gets the property prepped (zoning/water/sewage/utilities/access/egress/cleared/site development) for the franchisee to build their restaurant. Then, they in turn lease this location to the franchisee. There is a significant markup in the difference between what the corporate office pays for the rights to the land and what they in turn charge the franchisee. Margins with this segment exceed 25% and often on some individual leases more than 50%. Although, not the driving force of absolute dollars contributed to the overall profit of the company, the real estate arm of a fast-food chain leverages up the overall profit of the company.
Of the three segments of revenue customarily found with a chain of restaurants, Chipotle Mexican Grill, Inc. only operates the first segment. Thus, of the three segments noted above, the standard operating model known as corporate owned restaurants, which produces the lowest overall operating margin, is the ONLY segment Chipotle utilizes to generate sales. Take note, franchising utilizes others’ (franchisees) capital to construct/equip and start-up a new restaurant. Chipotle must use its own capital to carry out the construction, equipping and initial start-up of a new restaurant. This model difference impacts the ability to truly grow at exceptional rates for extended periods of time.
Thus, at the industry level, Chipotle Mexican Grill, Inc. can not match what other similar operations can do with potential growth.
Within the corporate owned restaurant segment, Chipotle has trouble matching the industry standards too. Again, McDonalds has set the standard. Utilizing a vast supply chain, a marketing/advertising program, strict conformance requirements and a deep management program, McDonalds has proven year in and year out that generating between 12 and 16% operating profit margins are expected. This includes this segment’s share of the overall corporate organization’s costs. Net profits from this segment are between 9 and 11% annually. On average over the last six years, Chipotle’s operating profit is a mere 7%. Only during this last year has Chipotle demonstrated dramatic improvement to the operating margin driven by economy of scale with sales. Just understand, one year of reasonable performance does not justify ‘irrational exuberance’.
One last area of industry standards that impacts value. Every company reports ‘risk factors’ in their annual reports. McDonalds’ risk factors are similar to Chipotle. They both mention the overall economy and how important it is that consumer demand impacts their ability to generate sales etc. But there are differences between the two operations. For example, McDonalds writes about their food supply chain and how they have management systems and a wide variety of suppliers. They are exposed to risk for certain products due to limited suppliers. In the end, McDonalds states that supply may ‘increase costs or reduce revenues’.
Whereas, when Chipotle Mexican Grill, Inc. writes about their supply chain risks, they state it as ‘… supply of ingredients could adversely affect our operating results’. Notice the difference in the language, in effect, the economy of scale and the long-term relationships McDonalds has developed limits their exposure to increased costs or reduction in sales. Chipotle Mexican Grill, Inc. uses stronger terms to indicate that issues within the supply chain can substantially impact the profit of the company.
This example of risk comparison is just one of the many that the two entities face but, McDonalds has the upper hand. Other risk factors include:
- Ingredient costs due to climate or sustainability;
- Federal and state laws;
- Labor;
- Cybersecurity;
- Reliance on information technology;
- Litigation;
- Lease negotiations for new sites;
- Financing
With all of these, McDonalds has the upper hand due to experience, size and stable operations. Chipotle still has many more years of operations to gain the experiences necessary to control the associated risks and their costs.
Thus, the ability of Chipotle to match the operating profit margin of other organizations is still several years away. Although improving, Chipotle’s risks will impact the ability to instantly match the operating profits of other large operations.
With the knowledge of both the financial performance and the industry’s standards of performance, a value investor can now determine intrinsic value.
Chipotle Mexican Grill, Inc. – Intrinsic Value of a Share of Stock
There are about six popular intrinsic value formulas. Add to this another two dozen or so variations of those six and there are literally more than 30 intrinsic value formulas. They key to identifying intrinsic value is using reasonable data points, expectations and thoughts. A reader can visit the internet and request intrinsic value for Chipotle and get some crazy numbers. Go back to the purpose of intrinsic value, it is the amount a rational individual would pay to own the rights to the respective security. Thus, it is important to understand what a buyer of stock would receive in exchange to own a respective share of Chipotle Mexican Grill, Inc. As illustrated in all articles on this site related to intrinsic value; the intrinsic value formula outcomes are broken out into the three major groupings of balance sheet, income statement and cash flows.
Balance Sheet Based Intrinsic Value
There are three ownership rights to any investment. The primary right is a return on one’s investment. With stock, this is characterized via dividends. Secondly, the owner has the right to vote their share to set the course of policies, management and directors. Lastly, an owner of stock has the right to sell the stock at any time in the future.
To be clear here, only the last ownership right is what a value investor would receive for this investment. Chipotle pays NO DIVIDENDS whatsoever. Thus, there is no value tied to dividends. Secondly, ownership of a few hundred shares isn’t going to change the policies nor management style or even who directs the company. Thus, the only benefit is the right to sell the stock in the future. With Chipotle, the only financial gain is to buy the stock low and sell it high and earn a good gain from the interim holding period.
This immediately eliminates one of the popular intrinsic value formulas, dividend yield.
Since the dividend yield is an equity section intrinsic value formula, let’s continue with another equity value formula, book value. Chipotle’s book value per share is $83.
With the balance sheet, a third and informative intrinsic value formula is tied to liquidation; how much would an owner of a share of stock get in case of bankruptcy or forced liquidation, i.e. the extreme step of folding up the company. Unfortunately, Chipotle only owns a few legitimate assets with any permanent value. Both sides of the balance sheet are oriented around those leases explained above. In effect, Chipotle can not just easily liquidate, it would take years to wind down the affairs of this company and this process will effectively consume the none leased assets such as investments, cash etc. The best possible outcome under a liquidation plan would be about 40 cents on the dollar of book value per share. The most likely outcome would be zero value for shareholders, IF the company had to liquidate. Thus, the book value is the best intrinsic value tied to the balance sheet formulas. And this value is contingent on the requirement that Chipotle continue with operations for several years into the future. It is unlikely that Chipotle will simply fold up; after all, it is a good operation and its product is well received by consumers. Thus, there is certainty related to continued operations.
Income Statement Based Intrinsic Value
Income statement based intrinsic value formulas key in on earnings. However, the formula requires three distinct pieces of information. The first is of course earnings. Not just the most recent earnings, but the average over the past three to five years. In addition, are the earnings increasing or decreasing. Secondly, the formula requires a discount rate. A discount rate is a complex outcome taking into consideration four major factors. For brevity with this this article, Chipotle’s discount rate is set at 11.5%. The third and final piece of information is the growth rate. This is the expected growth rate over the next seven years. What is the expected growth rate on average during this upcoming period of time? As determined in the financial data section above, Chipotle can expect a growth rate between four and six percent per year for the next seven years.
Now with the three pertinent pieces of information, intrinsic value can be derived based on earnings. To illustrate the extremes outcomes can generate, the formula will have three outcomes. The first, is ‘Conservative’ based. The second outcome and the one preferred and advocated by this site’s facilitator is ‘Reasonable’ in nature. The final result is ‘Liberal’ with its intrinsic value formula inputs. Each of them are explained and calculated in the following subsections.
Conservative Approach
When determining intrinsic value with a conservative approach, the idea is to use stronger discount rates and slower growth rates in order to generate an overall lower outcome value with the intrinsic value formula. The formula itself is the standard net present value formula commonly used with finance. Here, future earnings each year are determined based on the historical input and then these outcomes are discounted back to today’s dollars. Basically, what is the current average earnings and then with a conservative growth rate, how much is expected to be earned over many years into the future. Then, applying a discount rate against that future set of earnings, what is the aggregated value in today’s dollars.
Using the average earnings of the last three years at $540.15 Million per year with a more conservative discount rate of 12% and a growth rate of 3.5%, cumulative earnings over the next 25 years discounted to today’s dollars equals $5.5 Billion market value. With 28.16 Million shares, each share is worth around $196 each. Adjusting this outcome for interest and income taxes, the net result is around $161 per share.
Reasonable Approach
Changing this formula to a more reasonable set of data points, i.e. a discount rate of 11.25% and a growth rate of 4.75% provides an overall market value of $6.172 Billion, or $219 per share. As with the conservative approach, adjusting this outcome for interest and income taxes, the intrinsic value per share is approximately $178 per share. Take note, some so called experts with net present value formulas will state that a terminal value should be included in the formula to present a cashing out, i.e. winding up of affairs at the end of this formula. With Chipotle, there is no terminal value. This is because the entire operation is a function of leases. Once those leases expire, Chipotle no longer has rights to those sites. If they do not renegotiate an extension, the respective restaurant must close up shop and its over. In effect, Chipotle must make its money during the lease. The earnings reflects the earning during the leases. Yes, there will be cash in the bank at the end; but this cash is directly associated with the earnings made during those final years of operations. The ending cash and other current assets are already included in the formula. Again, there is NO TERMINAL VALUE. Chipotle will have no fixed assets to sell, no real estate that has appreciated in value, nothing other than current assets that are directly there because of prior years earnings.
Liberal Approach
Using the same formula but utilizing more liberal values will result in a higher valuation. However, with a liberal approach, the average earnings is also increased to reflect the best year of the three look back periods. In this case, earnings start at $886,327 (the value tied to 2021). Furthermore, the discount rate is dropped to 10% and an improved growth rate of 6.5% is factored into the result. The market value jumps dramatically to $14.05 Billion or $499/Share. Adjusting for interest and taxes, the final intrinsic value is right around $395 per share.
In summary, the liberal approach doesn’t even come close to the current market valuation of $1,400 per share. The liberal approach reflects the best year with overall earnings over the lifetime of this company and an incredible growth rate of 6.5% (which in layman’s terms means that Chipotle will double in size every 11 years). This is simply unrealistic. Add to it a low discount rate of 10% for this kind of operation and you have a very liberal formula outcome. To give you an idea, McDonald’s discount rate is around 9% and its been in business for 60 years and is a DOW listed company. Even the reasonable approach uses a strong growth rate of 4.5% but only because Chipotle has demonstrated a good growth over the last ten years and since it issues no dividends, it is likely to continue funding this high growth rate for several years to come. Under the reasonable approach, if the starting point is a reflection of the most current year earnings and not the look back average of the last three years, the outcome improves dramatically to $369/share, $295 per share adjusted for interest and taxes. But without confidence that Chipotle can continue to maintain this level of operating profits, using a higher starting point is unwarranted.
In summation on a per share basis the outcomes are as follows:
Approach Pre-Tax Value Net Profit Value
Conservative $196 $161
Reasonable $219 $178
Liberal $499 $395
Reasonable (Using Current Earnings as Starting Point) $369 $295
Cash Flows Based Intrinsic Value
The cash flows approach is similar to the income statement approach. Certain investors claim the cash approach is superior to the income statement approach as it also takes into consideration the impact related to the balance sheet. For those of you new to understanding financial statements, the cash flows statement reflects the net profit adjusted for how other forms of cash inflows and outflows are documented on the balance sheet. For example, Chipotle’s net profit on 12/31/2020 was $356 Million. This is considered the accrual net profit and gets adjusted based on whether certain expenditures were actually paid or prepaid. Thus, the net profit is adjusted for these cash related issues. During 2020, Chipotle had $613 Million of non-cash adjustments mostly related to depreciation/amortization, deferred taxes and stock compensation taken as a deduction on the income statement but wasn’t paid out in the form of cash. On the flip side, Chipotle did have to pay out in cash for past deductions about $446 Million for income taxes recorded in prior periods, lease obligations and prepayments required in their business. Altogether, the net cash Chipotle earned from their normal operations was $664 Million. Thus, cash from operations exceeded their net profit by $308 Million.
Some investors place greater importance on this additional cash as value tied to intrinsic value. This is true within a very restrictive set of circumstances. This is not the case with a company needing this cash to fund the growth of new restaurants. Altogether, Chipotle used $373 Million to invest in new operating leases. In effect, the benefit gained from operations of $308 Million was all used plus more to acquire new leases to add more restaurants to the portfolio. Thus, calculating intrinsic value tied to cash flow will result in a LOWER value than the methods under the income statement section above. For those readers not familiar with this intrinsic value formula, it is often referred to as the discounted FREE CASH FLOWS method. The free cash flows method is much more effective with highly stable, fixed asset intensive operations such as REITs, hotels and mining operations. It is generally frowned upon for companies that will not end up with terminal assets with some kind of market value.
To add onto this, Chipotle doesn’t pay out dividends; however, it did spend $54 Million to buy back stock. Here’s a company wanting to finance growth, yet it buys back some of the stock in the market. It is buying back stock at market prices that far exceed the intrinsic value of the stock. This is a RED flag in any value investor’s book.
Chipotle Mexican Grill, Inc. – Summary of Intrinsic Value
With a book value of $83 and a long list of significant risks, value investors should err with caution towards more conservative data as the basis in the intrinsic value formula. However, Chipotle has reached the level of a stable operation, not yet a highly stable operation; but, stable nonetheless. This allows a value investor the necessary substantiation to elevate the data towards reasonable expectations. Liberal rates for intrinsic value are not only troublesome, but create unrealistic results and with any fast growing company. Any outcome other than the required tremendous growth into the foreseeable future will result in losses to a value investor.
Overall, using the reasonable guidelines as stated above, the intrinsic value of a share of stock for Chipotle Mexican Grill, Inc. is $178 per share. Any value higher is fraught with too much risk that is just unbearable for any prudent responsible investor. Remember, this is NOT a highly stable company yet, it does not have full economy of scale nor does it have the long-term experiences to address corporate wide issues with the least amount of costs. In ten years, it will be a different story.
With this said, the intrinsic value will move forward in leaps and bounds IF the company continues to improve its bottom line and can continue its current growth rate. It is possible, that the intrinsic value could grow at $40 per year over the next three years provided Chipotle adheres to the performance standards it set in 2021. For now, the intrinsic value for 2022 is set at $178 per share.
Chipotle Mexican Grill, Inc. – Margin of Safety
As with any investment, there are risks. The goal with a margin of safety is to buy the stock at less than intrinsic value to accommodate those risks. Risks include using the wrong formula or data points. There are also economic wide risks, industry related risks and risks at the company level. Above, it was explained about the various risks fast-food restaurants must address to keep moving forward. Unlike better established operations, Chipotle’s risks are inherently greater due to their novice experience and economy of scale. Risks at the company level are worth four to five percent, at the industry level, another two to three percent. But the real risk factor are the data points used in the intrinsic value formula. Here, overstating growth by as much as one percent equals $12 to $15 of value in this range. Thus, a value investor must maintain some perspective here.
Overall, it is a good company, great product and so Chipotle will always be in demand by the consumer. Assuming the corporate level risks and industry risks, a discount of seven percent is warranted. In addition, another $12 of discount is required to compensate for the risk of using incorrect values in the intrinsic value formula. The end result is a discount of $13 for risk and $12 for formula error. Total discount or margin of safety is $25; thus, the buy price is set at $153 per share.
At $153 per share and a book value of $83 per share along with the high growth rate of Chipotle, the value investor minimizes the downside potential and once the market recovers to a fair and reasonable price, the value investor will do extremely well. Initial market recovery price is set at $320; see the liberal intrinsic value outcome.
Current Market Price Experiencing ‘Irrational Exuberance’
Above, a rational approach was illustrated to calculate a reasonable intrinsic value for Chipotle Mexican Grill, Inc. Remember, this is a company that is only 29 years old and only has 2,900 restaurants nationwide. For comparison, Wendys has 6,800 locations and McDonalds has 40,000 restaurants worldwide. So in comparison, this is a young and growing company. It still has a long way to go to maturate into a highly stable fast-food operation. It is going to make mistakes while it grows.
As for ownership, 19 Million of the 28 Million outstanding shares are held by institutional and mutual fund groups. There are another 505,000 held by four individuals that operate Chipotle. The remaining 8.5 Million are held by small funds and individuals. So how did this market price come to be? First, let’s look at Chipotle’s lifetime share price in a graph.
The last time the share price was below $200 was back in late 2010. The graph clearly identifies the E. Coli scare in late 2015 and how it took four years for Chipotle to regain its market share, revenue and of course the corresponding share price.
Again, why is the share price so high in comparison to Chipotle’s intrinsic value?
The answer is prestige.
The initial investor during this company’s pre-public existence was McDonalds! Think about the prestige this single corporation brings when it was the first big investor in this chain back in the late 90’s and was the largest stakeholder when the company went public in 2006. Over a course of a few offerings, McDonalds divested itself from Chipotle. But, McDonalds implemented the culture, systems and processes to make Chipotle the success it is today. The share price is a reflection of the belief by the holders of stock that this company will someday be the next McDonalds. McDonalds lent its reputation to Chipotle and in turn the shareholders believe this warrants unbridled behavior with the stock price.
This restaurant chain has doubled its number of restaurants in eight years; sales have doubled in seven years even with the E. Coli incident; and, Chipotle is now synonymous with quality fresh food.
The reality is this, Chipotle is still a small fast-food chain. Secondly, it still has a long way to go to secure sourcing of its ingredients and acquiring the human resources to continue this growth. It is going to get more and more difficult as the company broadens its footprint to lock down resources. All of this affects earnings and since Chipotle pays no dividends and still has another ten or more years to become recognized as a highly stable operation, the current market price has nowhere to go but down. The giddiness of owning a good company that was essentially started by a renowned corporate behemoth will wane without rewarding the shareholders for the risk they take when they spend $1,400 for a share of stock that only earns in its best year to date $25 per share. At this rate, it will take more than 50 years to get your money back. And this assumes all of the earnings would be paid out as dividends.
This irrational behavior with this stock price meets reality over time. How long will institutional and fund investors tolerate no dividends? Yes, the company is growing quickly, but at some point this has to turn into a return on the investment for these investors. Some institutional and fund investors will sell in order to take advantage of these high market prices and take whatever gains they can, but this then requires individuals to buy these positions and quite honestly, any individual or independent fund that reads and understands value will just simply not play that game.
This site’s Value Investment Fund only includes this particular company in its restaurants pool for the purpose of illustrating how the market can act inappropriately related to certain investments. This is an extreme example of an overpriced investment. The price would have to drop below $250 per share just to begin inclusion in the decision matrix for the restaurants pool. Any purchase of a share of Chipotle for more than $300 is just simply not investing but speculation. Act on Knowledge.
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‘Quality is still our recipe’ – Dave Thomas, Founder of Wendy’s
Wendy’s is the second largest publicly traded informal eating-out (fast-food) hamburger chain. Its current market capitalization places it around $5 Billion. Therefore, it falls into the mid-cap arena of stocks. At the time of this article’s inception, November 2021, Wendy’s was trading on the NASDAQ at $23 per share. Its intrinsic value is a little less than half the market value and a value investor’s buy point is around $8 per share. The company does pay a small dividend. Current dividend yield is slightly less than 2%. Overall, the company is profitable but stagnant related to growth. Stated succinctly, Wendy’s is nowhere near worth current market value of more than $20 per share.
This company runs the industry financial model commonly used with other fast-food restaurant chains. It has three revenue and expense segments of operations. The first and core segment is the traditional corporate owned locations. Wendy’s has 361 company owned stores. As such, they have a traditional profit and loss calculation associated with this segment. A second segment and the real driving force of profit is the franchising arm of the company. There are 6,467 franchisees, with corporate owned stores, Wendy’s totals 6,828 restaurants. This segment is driven by the 4% franchise fee placed on all sales of the franchisees. Similar to McDonalds, the core source of profitability stems from the franchising aspect of operations. A third and not as profitable as franchising is the real estate arm. Just like McDonalds and other well managed restaurant chains, Wendy’s negotiates long-term leases of property in ideal locations and in turn negotiates beneficial long-term leases with franchisees to pay rent for the use of that land. The franchisee uses their capital to build the store, equip it and initiate operations at that site.
Unlike McDonalds, Wendy’s has failed to generate any profit from its corporate run segment. The corporate run stores generate a 14.9% operating margin; but once you add this segments’ share of depreciation, G&A and other allocated costs, this segment loses money for Wendy’s. In comparison, McDonalds generates an 11.4% net profit after taxes from this same segment. This greatly impacts the intrinsic value formula as will be illustrated later. For now, it is important to look at the overall picture. How much is a corporate owned store worth, and how much is a franchisee store worth to an investor?
Wendy’s – Intrinsic Value of Stock Driven by Asset Valuation and Royalties
A well run fast-food operation site is worth between $1.3 Million and $1.7 Million net of associated liabilities for the physical assets. This net worth includes the long-term rights to a particular geographic location and access to a stable and qualified workforce. To provide a conservative approach to valuation, a mid-range value is used to approximate the value of each of the corporate owned restaurants. Using a $1.5 Million valuation (the name Wendy’s bumps the site locations’ value higher than a none recognized name) and with 361 stores, Wendy’s corporate owned assets have a reasonable fair market value in the range of $525 Million to $550 Million.
The second piece and more lucrative to Wendy’s is the franchising arrangement. Here, a different application principle is applied. In a franchising arrangement, the franchisor is getting paid for the use of the name. Four percent of all sales equates to $415 Million in 2020. In addition, Wendy’s receives a license fee from the franchisees which equates to an additional $30 Million. However, much of the costs associated with franchising is directly tied to the license and not so much with royalties. Since a typical well-run establishment will earn an 11.4% profit after taxes without a royalty fee, and assuming a reasonable 28% cumulative tax rate, the actual profit before royalty expenditure is around 15.8%. Thus a 4% royalty is about 1/4 of the restaurants’ value. Therefore, it is reasonable to deduce that a franchisee operated store is worth about $375,00 (1/4 of $1.5 Million valuation). With 6,467 franchisees and a franchisee asset valuation of $375,000 each, this equates to a total combined value of $2,425 Million ($2.425 Billion) for the franchise locations. A value investor would ask if this is reasonable. Let’s look at this in a slightly different way.
A typical Wendy’s will generate around $1.7 Million of revenue in a year. With a 4% franchise royalty, each location must pay Wendy’s $68,000 per year in royalties. Thus, Wendy’s gets its $375,000 of value every 5.5 years which is indeed reasonable. Therefore, the asset valuation principle used above for franchisees is a fair viewpoint or estimate of total value.
The last segment is land leasing. Wendy’s owns the rights to the leases and collects fees from franchisees. The difference between rental income and rental lease costs are around $107 Million. Assuming some reasonable costs associated with monitoring and administering this program, Wendy’s is easily clearing $50 Million per year from this segment of revenue sources. Using a basic multiplier of 6X of this value, this adds another $300 Million to the overall asset and royalties’ valuation.
Thus, in total, Wendy’s asset valuation is as follows:
Value of Corporate Owned Stores $550 Million
Value of Franchisees as an Asset 2,425 Million
Value of Land Lease Rights 300 Million
Total Asset Valuation of Wendy’s $3,275 Million ($3.275 Billion)
There are currently 226 million shares outstanding in the market. Thus, each share is worth about $14.50.
This method of valuation is asset driven and not income driven. Income driven valuations use a different formula to determine intrinsic value.
Intrinsic Value of Stock Based on Income
Valuation based on income requires several underlying elements present to have confidence in the outcome. Wendy’s satisfies these elements:
- The entity must have completed one or more economic cycles (10 to 14 years);
- Income must be positive from normal operations on a consistent basis, i.e. more than 75% of the years in operations;
- The entity must be financially stable; this is vouched from the balance sheet; AND
- The entity must have backup resources to provide liquidity during lean times.
Wendy’s satisfies all the required elements. The company has been in business for 52 years. Secondly, it rarely generates a loss. See this historical depiction:
2018 is an anomaly associated with the spin-off of Wendy’s rights in Arby’s.
The most important piece of information to gather from this is that Wendy’s is indeed profitable from year to year. It isn’t wildly profitable, but it is profitable.
In addition, the company has borrowing capacity along with over $500 Million of an equity position to withstand an extended economic downturn. Therefore, it is acceptable to use an income-based formula to determine intrinsic value.
A sidebar is appropriate here. Many readers will wonder why not use the free cash flow of the company adjusted for growth and discount the future free cash flow. This is one of the most common tools readers discover when asking about intrinsic value. However, utilizing a discounted future cash flow stream is highly dependent on accurately estimating future cash flow for the entity in question. This is really easy for DOW and Large-Cap companies. For Mid, Small and Penny stock categories, it is an attempt at frustration. Look at Wendy’s cash flow for the last three years. It is highly volatile and worse, it is inconsistent from line to line for cash flows from operations. Thus, any outcome from this tool would require the user to make lots of adjustments to the cash flow value in order to generate a reliable result. Most readers are not CPA’s and as such, are not aware of how to make these adjustments when performing this step. The outcome would be untrustworthy.
Now the question is: ‘How much is Wendy’s income?’.
In 2018, Wendy’s sold off its ownership rights carried over from 2012’s divesture of Arby’s. Adjusted for income taxes, Wendy’s gain off the sale of that investment approximated $360 Million, again, net of taxes. Thus, in 2018, normal operations for Wendy’s netted $100 Million ($460M – $360M). Using the past seven years of income including income reported through the third quarter of 2021 (released on 11/10/21); Wendy’s averages $145 Million per year as net income after taxes. This even includes the impact of COVID-19 in 2020 and in early 2021.
To value this average $145 Million per year net income, a second piece of information is required. It is called the ‘discount rate’. In effect, it is a value applied against a known to determine its long-term outcome (result). The ‘discount rate’s’ application is an inverse operation. The higher the discount rate, the lower the resultant value. The final formula is a finance formula called Net Present Value. Basically, we assume the net income will exist at a similar value indefinitely and those payments out into the future are discounted back to a value in today’s dollars. With each successive year, the current value of that longer time out into the future is significantly less tied to this discount rate. Once the formula starts discounting beyond the 18th year, the additional inclusive discounted value falls below four cents per share. In effect, it isn’t necessary to determine the net additional contribution amount beyond 20 years as it will have no bearing on the end decision related to intrinsic value for this stock. In addition, over this extended period of time, there will be economic recessions and this may produce negative profits during those respective years. Thus, for investment of this nature, using the current average of the most recent seven years is a reasonable expectation of future earnings.
One last note to include about the use of this formula. Many mathematical professionals will tell you that the future income stream for Wendy’s will increase, referred to as a growth rate into the future. The author agrees with the concept of using a growth rate, but disagrees that it is applicable in this case. Look at the pattern above for Wendy’s income. First it is highly volatile; secondly, Wendy’s has not demonstrated real growth of any sort during the last seven years. Growth of one or two percent is not real growth, it isn’t even keeping up with the overall growth of the economy. A value investor has to be realistic, real growth means three and four percent per year, year over year. This is simply not happening with Wendy’s. Thus, including a growth rate with Wendy’s formula isn’t going to really make any real difference with the end result. It may change it by one or two percent; but one or two percent on a $10 outcome is only 20 cents or so. It isn’t going to change a value investors decision model. Thus, there is no need to determine and include a growth rate in the formula.
The question now is: ‘What is an appropriate discount rate?’ The answer is a function of four core elements of determining discount rate. They are as follows and include a simple definition:
- Risk-Free Rate – This is the rate that exists with treasury notes. It is what most investors will accept without any risk.
- Equity Risk Rate – A rate an investor is willing to accept given the position they fall within the spectrum of ownership rights, i.e. equity positions range from 4% to as high as 7%. Bond holders are in the 3% to 5% range. Secured bond holders have less risk involved and are in the 2.7% to 3.5% range.
- Size Premium – An additional 1% to 4% depending on the size of the company. For example, Walmart’s size premium is around 1%. Mid-Cap investments are in the 2% to 3% range whereas penny stocks are slightly more than 4% premium.
- Specific Risk – A factor associated with the purpose of the investment and the ability to sell the respective investments in a timely manner. In this case, Wendy’s is stable, and it is easy to dispose of a stock position with Wendy’s. A bond position would require a higher specific risk. Overall, specific risk ranges from 0% (McDonalds’ stock position) to as high as 4% for an over-the-counter stock purchase.
For Wendy’s the discount rate (November 2021) is determined as follows:
- Risk-Free Rate 2.25%
- Equity Risk Rate 6.25%
- Size Premium 2.00% (Mid-Cap Value)
- Specific Risk 1.00%
Therefore, a reasonable discount rate for a Wendy’s investment is around 11.5%. Again, the higher the value, the lower the result with the discount formula. What is the market value of Wendy’s income?
Formula: Net Present Value of Future Earnings
= $1,117,924,000
If Wendy’s discount rate were higher, 14%, the income stream’s value would be less at $961,000,000. At 8%, the result is $1,424,000,000. This is important to understand, there is a $463,000,000 spread between the two extremes. With 226 million shares in the market, this spread can impact the value as much as $2.05 per share. As stated multiple times in the lessons about value investing, intrinsic value calculation is NOT an exact science. It is a range; your goal is to try and keep that range as narrow as possible to provide a high level of confidence with its outcome.
Using income to determine intrinsic value for Wendy’s, the final result is $1,118 Million divided by 226 million shares or about $4.95 per share. At the high end (8% discount) the value equates to $6.30/share; at the low end it is $4.25/share. Thus, Wendy’s is a good investment if the value investor relies solely on income to determine an appropriate intrinsic value AND the market price per share could dip down below $5 per share.
Many of you, especially investment analysts, are having a difficult time accepting an intrinsic value of $5.00 per share especially since Wendy’s market price has exceeded $10/share for the last six years. The income method is extremely conservative when determining value. It is highly reliant on the average of many years of income, thus recent higher earnings are dampened with their impact due to the averaging effect. Therefore, the formula’s outcome could be relatively understated if the company’s net income will continue to improve in the near future and of course the outcome value will have the opposite impact if the company’s recent earnings are declining; which is the case with Wendy’s. In effect, the $5 per share intrinsic valuation is generous. Overall, this intrinsic value method provides a high level of confidence when stating intrinsic value. With Wendy’s, $4.25 is the valuation or for sake of simplicity, $5 per share. There is a high level of confidence that Wendy’s is worth at least $5 per share. Still, this appears and feels low for such a highly visible company. After all, we are talking about 6,828 restaurants.
Are there other alternative intrinsic value methods?
Wendy’s – Intrinsic Value of Stock Based on Book Value and Dividend Yield
Another commonly accepted method to determine value is combining existing book value and the result of the dividend yield.
For those of you that are not familiar, dividend yield is simply the value of receiving a lifetime of dividends from an investment. In this case, Wendy’s pays about 38 cents per year in dividends. Since dividends are an equity risk, an investor could apply an acceptable minimum discount rate and determine the value of all future dividends. In this case, a 6.25% discount rate (see equity risk rate from above) is reasonable. With a 6.25% equity discount rate, 38 cents per year is worth approximately $5.75 per share.
Current book value for Wendy’s is $2.40 per share. Add the two together and the stock’s intrinsic value under this method is $8.15 per share.
There are some drawbacks to this method. First, the book value is predicated on the ability of Wendy’s to liquidate in a reasonable manner and end up with $2.40 per share of cash to distribute to the shareholders. The key here is that Wendy’s is more valuable as a going concern than its assets sold and liquidated. A perfect example is McDonalds. McDonalds book value is a negative $5 per share. Thus, McDonald’s is worth zero if liquidated. McDonalds real value comes from its name and brand. Therefore, book value with a highly stable, long-lived company is not indicative of the value of the assets liquefied and the liabilities paid off.
Wendy’s name and brand has value that another entity would snap up if Wendy’s had financial troubles. Overall, Wendy’s, just like McDonalds, is worth more than its book value. The question is how much more?
Intrinsic Value of Stock
What this does tell us is that when combining book value and dividend yield together an intrinsic value of $8.15 is going to be low. This also lowers the confidence that the income method result of $5 per share is also low. If a value investor relies solely on the asset valuation including the value of the royalties, $14.50 per share seems high. Under that method, there are a lot of assumptions associated with the leases on the properties; reliance that all franchisees run good operations and generate after tax profits of 11.4%; and an assumption that the net value from the real estate segment is high. Thus, the value derivative of the asset valuation along with royalties is liberal with its outcome.
The intrinsic value of Wendy’s lies somewhere between $8.15 per share driven by book and dividend yield values and $14.50 based on asset valuations. Remember, the key to determining intrinsic value is to narrow the range. $14.50 is too high; we know it is overstated but not by some unreasonable amount, adjusting it downward 25% (an 80% factor) improves our confidence in the outcome dramatically. Using an 80% factor, this price drops to $11.60 and we know that $8.15 is low because Wendy’s brand name and going concern are not issues related to long-term operations. There is no doubt, the company will be around in seven years. Thus, it is safe to improve this value 25% to $10.20 per share.
The final outcome is that intrinsic value on the low end is $10.20 and on the high end $11.60. It isn’t necessary to derive an exact number. Intrinsic value is a base value and therefore, using $11 as our base is quite reasonable.
There is one last check mechanism. The founding fathers of value investing (Benjamin Graham and David Dodd) developed a simple formula to determine a value for a security. The formula is to take the current earnings and multiple this by a factor of 8.5 plus 2 times the anticipated future growth. Assuming Wendy’s experiences great growth for the next seven years and this growth rate is a factor of three percent (see above with the net present value formula), what is the value for Wendy’s?
Earnings of $145 Million (from above) times ((8.5 plus (2X3% growth rate)) = $145 Million X 14.5 or $2,102,500,000. On a per share basis, this equals $9.30 per share.
Thus, even under the formula advocated by the fathers of value investing, the $11 per share value outcome is high. And, the formula assumes a very strong three percent growth rate per year for next seven years. A three percent growth rate is somewhat risky to assume given that Wendy’s has only experienced a one to two percent growth per year over the last few years. So, how does a value investor mitigate this risk?
For value investors, risk reduction is essential. The number one tool to reduce investment risk is to buy stock with a high margin of safety, a strong discount to the intrinsic value. A good and very effective principle is to reduce intrinsic value by at least 25%. Setting the buy point at $8 per share and increasing it around $1 per share every two years is a reasonable approach for the near future (six years or so).
Given that the current market price is over $23 per share and the last time Wendy’s stock price was $8 per share was back in 2014, value investors are going to have a long wait to have an opportunity to buy. Yes, you could buy the stock at $11 or $12 a share and still have a high level of confidence that this investment will reward you. All you have done is simply increased your risk that if it takes take a long time for the market price to recover high enough to sell, your effective annual return will be decent, not great, just decent. At $8 per share, it will not take long for the market price to recover to reasonable market price of $16 or more per share. The return on the investment will be extremely high.
In general, Wendy’s is not a good investment for value investors. It is not necessary to depend on a single stock to determine the outcome for a value investment portfolio. The key is to determine buy points for several members of a similar pool of investments and wait with patience. At some point, one or more of the members will dip to the preset buy point and a value investor has an excellent opportunity to generate an outstanding return on their investment. For Wendy’s, a value investor may have to wait a few years to see the market price dip to $8 per share. But when it does, it becomes an excellent investment and will provide a very high return when it is ultimately sold. Act on Knowledge.
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“We are on an endless pursuit to create uplifting experiences.” – Shake Shack’s Mission Statement
One of the members of the informal eating out industry, a.k.a. fast-food restaurants, is Shake Shack. Shake Shack is one of the few fast-food restaurants that sells beer and wine at a limited number of its locations. The company is relatively young by any business standard opening its first restaurant back in 2001 and going public in 2014. Thus, the company does not qualify as a value investment opportunity but is used as a comparative tool with this site’s Value Investment Fund’s Fast-Food Restaurants’ Pool.
In general, Shake Shack’s market price is several times greater than the company’s intrinsic value. It is trading at this high price purely on conjecture that it will morph into the next McDonald’s. Based on its business plan, historical earnings, and capital raising capacity; it will take every bit of twenty (20) years to justify the current market price – trading at more than $70 per share (November 2021). No value investor in their right mind would spend $70 plus on hope. It is simply irresponsible.
To make matters worse, Shake Shack is not following the industry financial model. The current informal eating out financial model includes traditional corporate owned locations augmented with franchising. For example, McDonalds has a 13:1 ratio of franchisees to corporate owned locations. In addition, the more successful fast-food operations utilize a real estate leasing program that significantly improves the bottom line and the respective intrinsic value of the company. Shake Shack currently has around 350 locations of which only two dozen are franchisee operations. On page 10 of the 2020 Annual Report, under Growth Strategies, management clearly states that they believe that the greatest opportunity for growth ‘… lies in opening new, Company-operated Shacks’. This mindset limits the ability of the company to grow quick enough to justify the current market value. Even under optimum conditions, it will take at least 15 years to fulfill the current market valuation. The following illustrates the dichotomy of two different worlds, the current market valuation and intrinsic value of Shake Shack.
Shake Shake – Value Derived From Asset Valuation
A typical restaurant costs around $2.4 Million to construct the building and insert the furniture and equipment. In addition, the company must sign a long-term lease to have rights to the land and for the landlord to provide some improvements to the property to accommodate a fast-food restaurant. Furthermore, there are start-up costs, technology and initial inventory to get a restaurant opened. Therefore, it is reasonable to calculate that a typical Shake Shack costs around $3.2 to $3.5 Million to open its doors. This initial investment range matches similar cost structures as noted in franchise offering circulars set forth by other informal eating out establishments.
A reasonable location development time frame to get a store up to normal sales is about 15 months. During this time period, additional capital is required to cover losses and cash requirements. In the end, it costs at least $3.5 Million to successfully get a location up to speed and working efficiently.
Reviewing Shake Shack’s balance sheet, approximately 62% of the assets are financed and the balance is directly sourced from equity (stock and retained earnings). Applying this formula to a new location means that Shake Shack invests about $1.3 Million into a new store and borrows the balance. This mirrors what a franchisee invests for other chains such as Wendy’s or a Burger King; McDonald’s is slightly higher due to a premium paid for one of their licenses.
It is safe to assume that $1.3 Million is the value for each store for the equity position (rights and value of the locations’ physical assets in excess of the associated debt instruments). Given this, then the overall value of Shake Shake is 350 (# on 09/30/21) stores times $1.3 Million apiece. Therefore, Shake Shack’s total market value is $455 Million. There are currently 39,134,400 shares trading in the market. Each share’s intrinsic value is then equal to $11.62.
This is going to be a big shock to those of you that are institutional investors or novice investors. But this is exactly how value investors think. Many of you are also asking, ‘Does this make sense?’
Shake Shack – Value Derived From Earnings
Well, let’s look at this from another perspective. Over the last three and half years, Shake Shack has lost $3.9 Million as a function of normal operations. Since inception as a publicly traded operation, Shake Shack has only earned $15.5 Million (through June of 2021), a meager 40 cents per share over a seven year time period. This averages to about 6 cents per year making this stock investment more a penny stock investment than a highly stable investment.
Since some of the operational income is expended to develop new locations and fund start-up costs, an investor could add this back to normalize income. Even if this equated to $80 Million, it would only add back about $2 per share in value. Succinctly stated, Shake Shack does not earn enough net profit, even with adjustments, to justify any market value of more than $5 per share.
Shake Shack – Value Driven by Book Value
There is a third way to look at this too. Shake Shack’s current book value is $10.66. A word of caution is presented here: Unlike operations that have thirty plus years of ongoing operations which drives book value with retained earnings, Shake Shack’s book value is sourced from its sale of stock over the last seven years. The sale of stock proceeds were used to build the 330 corporate owned locations.
If the company were to fold up business or liquidate in a reasonable fashion, it is highly likely that a good portion of the existing cash would be used to satisfy the long-term lease obligations in excess of the value of the respective lease assets. Currently, it is greater than $70 Million and this does not include penalties for early termination. It takes time to flip long-term lease obligations into a net positive position related to leased assets. With Shake Shake, it will take at least seven years to amortize out this negative lease position in comparison to the assets. Thus, when you take into consideration the negative lease position held, real intrinsic value is significantly less than book value of $10.66.
Shake Shack – Value Derived from Perfect Operations
There is a fourth way to determine intrinsic value. A typical well run fast-food restaurant will generate an 11.4% after tax net profit. You can review McDonald’s financials and using segmentation for corporate owned operations, you will calculate the 11.4% net profit after taxes. McDonald’s real profit is sourced from the franchisee and real estate model used in this industry. Again, neither of these segments exist with the Shake Shack financial model (12 franchisees out of 350 locations doesn’t qualify as a segment). Thus, an investor must rely on the traditional fast-food profit and loss formula from the traditional McDonald’s corporate run locations to determine after tax profit. There is no way as an investor you can use the total net after tax profit McDonald’s (currently 24%) generates as the barometer for Shake Shack, the two financial models are starkly different.
Shake Shack claims that each location is now averaging $74,000 per week in sales (see 3Q 2021 Presentation); however, the income statement states total sales for three quarters are $519.1 Million from 330 corporate owned stores which equals $40,400 per store per week. This equates to $2,100,000 in sales annually per restaurant. For comparison purposes, a McDonalds restaurant will generate around $2.9 Million in sales. At 11.4% profit, a typical store will net at best $240,000 per year after taxes. In effect, it will take 5.4 years to earn back the original investment in a store. This assumes the following:
- Actual initial investment is no more than $1.3 Million;
- New location gets up to normal sales immediately;
- Shake Shack’s profit and loss model matches McDonalds’ standard for core operations segment;
- Food delivery efficiency matches the standard set by McDonalds;
- There are no interruptions, economic downturns or legal issues.
Thus, even if everything went perfectly well, it will still take five and half years to get back your $11.62 valuation. At the current market price of $70 per share, it will take thirty plus (30+) years to earn your money back. And this assumes everything goes perfectly for 30 years, no economic downturn, traditional growth from year to year, no hiccups whatsoever just to get your money back. How long do you think you will wait to make a profit from an investment of $70 per share?
Shake Shack – Intrinsic Value of Stock
When you take into consideration all these different methods to determine value, Shake Shack’s intrinsic value is around $9 per share. Furthermore, a value investor would want a dramatic margin of safety before buying this stock. The market price would have to drop to around $5 per share to justify the purchase of Shake Shake as a value investment. This then leads to the real question, why then is the market price so high? Why are institutional investors so positive about Shake Shack? The answer is simple, institutional investors are gambling that some private equity firm will want to buy Shake Shack. They are in hopes that within a few years revenues and profits will improve and get inline with the fast-food financial model. There are no foreseeable buyers of Shake Shack. Furthermore, a buyer would need the stock price to drop down into the 20’s in order to generate any real interest in owning competition to other large informal eating-out chains. A private equity firm would convert the existing model into the standard industry model and then develop Shake Shack into a viable powerhouse fast-food chain. That is still years away. For those of you that are members of this site’s Value Investment Club, this particular member of the fast-food restaurants’ pool is included for the purpose of comparison and to validate the profit and loss model for a fast-food restaurant. Act on Knowledge.
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