absolute dollars<\/span><\/strong><\/a> 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.\u00a0<\/span><\/p>\nTo validate this business model, look at McDonald’s balance sheet, specifically the tangible assets section.\u00a0<\/span><\/p>\n![\"McDonald's\"](\"https:\/\/businessecon.org\/wp-content\/uploads\/McDonalds-BS-Assets-Section.jpg\")
<\/span><\/p>\nTangible 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.<\/span><\/p>\nWhat 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.\u00a0<\/span><\/p>\nBasically, 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.<\/span><\/p>\nIt is this discount rate that is used in multiple versions of the intrinsic value calculation.<\/span><\/p>\nIntrinsic Value – Setting the Discount Rate<\/span><\/strong><\/span><\/h2>\nA 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.<\/span><\/p>\nIn 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:<\/span><\/p>\n\n- 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?<\/span><\/li>\n
- 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.<\/span><\/li>\n
- 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.<\/span><\/li>\n
- 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.<\/span><\/li>\n<\/ul>\n
There is a five part formula to setting discount rates for every entity. The following walks the investor through the five steps.<\/span><\/p>\nStep I – Perfectly Safe Investment Yield<\/span><\/strong><\/span><\/p>\nUse 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%.<\/span><\/p>\nStep II – Additional Yield for a Pure Equity Position<\/span><\/strong><\/span><\/p>\nThe 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.<\/span><\/p>\nStep III – Risk Factor to Dispose<\/span><\/strong><\/span><\/p>\nIn 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.<\/span><\/p>\nStep IV – Industry Risk Factor<\/span><\/strong><\/span><\/p>\nThe 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%.<\/span><\/p>\nStep V – Economy of Scale<\/span><\/strong><\/span><\/p>\nJust 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. <\/span><\/p>\nThis 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.<\/span><\/p>\nCombined Discount Rate<\/span><\/strong><\/span><\/p>\nTo sum up the discount rate, add all the respective values together:<\/span><\/p>\n\n- Step I<\/strong> – Perfectly Safe Investment\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a02.5%<\/span><\/li>\n
- Step II<\/strong> – Desired Dividend Yield\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a02.75%<\/span><\/li>\n
- Step III<\/strong> – Disposal Risk\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.25%<\/span><\/li>\n
- Step IV<\/strong> – Industry Risk\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 1.25%<\/span><\/li>\n
- Step V<\/strong> – Economy of Scale\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0.5%
\n<\/span><\/span>Cumulative Discount Risk Factor\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a07.25%<\/span><\/strong><\/li>\n<\/ul>\nThere 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.<\/span><\/p>\nWith the discount rate set, an value investor can now proceed to utilize the best formula to evaluate total value for McDonalds.<\/span><\/p>\nIntrinsic Value – Appropriate Intrinsic Value Formula<\/span><\/strong><\/span><\/h2>\nThere 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.<\/span><\/p>\nBalance Sheet Formulas<\/strong><\/span><\/span><\/p>\nMcDonald’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.<\/span><\/p>\nSince 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.<\/span><\/p>\nCash Flow Formulas<\/strong><\/span><\/span><\/p>\nDiscounting 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.<\/span><\/p>\nWhen 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. <\/span><\/p>\nUnderlying 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.<\/span><\/p>\nThe 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).\u00a0<\/span><\/p>\nMcDonald’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.<\/span><\/p>\nDiscounted Earnings Formulas<\/strong><\/span><\/span><\/p>\nThe 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.<\/span><\/p>\nOne 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:<\/span><\/p>\nValue equals Earnings times ((a factor of 8.5 plus (2 times growth rate));<\/span>
\nMcDonald’s Intrinsic Value = Earnings X ((8.5 + (2XGrowth));<\/span>
\nMcDonald’s Intrinsic Value = $10.04 X ((8.5 + (2X3.5)); Assumes a growth rate of 3.5% per year;<\/span>
\nMcDonald’s Intrinsic Value = $10.04 X 15.5;<\/span>
\nMcDonald’s Intrinsic Value = $156 per share<\/span><\/p>\nThe 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.<\/span><\/p>\nA 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:<\/span><\/p>\nYear<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Comprehensive Income<\/span>\u00a0 \u00a0 Weighted %<\/span>\u00a0 \u00a0 \u00a0 Effective Income<\/span><\/span><\/strong>
\n2021\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$7,558\u00a0 Million\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a050%\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $3,779 Million<\/span>
\n2019\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a06,152\u00a0 Million\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a025%\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 1,538 Million<\/span>
\n2018\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a05,493\u00a0 Million\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a015%\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0824 Million<\/span>
\n2017\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a06,109\u00a0 Million\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a05%\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0305 Million<\/span>
\n2016\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a04,473\u00a0 Million\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a05%\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0 \u00a0 \u00a0 224 Million<\/span><\/span>
\nAverage\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $6,670 Million<\/span><\/strong><\/p>\nUsing 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<\/strong> the growth rate is 3.5%.\u00a0<\/span><\/p>\nWith 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?<\/span><\/p>\nMcDonald’s Growth Rate<\/strong><\/span>
![\"McDonald's\"](\"https:\/\/businessecon.org\/wp-content\/uploads\/McDonalds.gif\")
“to be our customer’s favorite place and way to eat and drink” – <\/span><\/strong>McDonald’s Mission Statement<\/span><\/h3>\n![\"McDonald's\"](\"https:\/\/businessecon.org\/wp-content\/uploads\/Consolidated-Revenue-McDonalds-2021.jpg\")
<\/span><\/p>\n![\"McDonald's\"](\"https:\/\/businessecon.org\/wp-content\/uploads\/Revenue-Matrix-from-Franchisees.jpg\")
<\/span><\/p>\n