McDonald’s Financial analysis

8 August 2016

Liability?Business Strategy Analysis: McDonald’s Corporation is the world’s largest fast-food chain in the restaurant industry, serving on average 69 million customers a day. Their stores are corporate or franchised owned, with franchising being highly beneficial to their success by producing 32% of their total revenue1. McDonald’s is in a highly competitive industry with market saturation because of low barriers to enter. The industry competes on price, quality, and service. McDonald’s faces competition with full-service restaurants and fast-food restaurants in the area.

Their main competitors are Burger King, YUM! Brands, and Wendy’s International. The industry has faced scrutiny on the quality of their products because of a more health concise society. McDonald’s strategy for success is based off of cost efficiency, product development, and marketing and promotions. These factors help form the strong brand that McDonald’s is today. Since their establishment with Ray Kroc, they have focused on driving their success from the 3-legged stool principal representing: McDonald’s employees, the owner/operators, and their suppliers2.

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The stool needs all three to have a good balance in order to function, without either one of the legs success cannot be achieved. All three of them work together to create new products, to reduce costs, and to achieve outstanding customer service. There is commitment in helping all three legs of the stool to succeed. The suppliers play a key role by providing high quality products and forming trusted relationships with them. The franchiser represents McDonald’s by being in control of own operations. They are highly beneficial because they allow McDonald’s to grow at a much faster rater and in new markets to create a global brand.

Also, economies of scale can be obtained by offering their products at a lower cost since it is a large scale. McDonald’s has implemented Plan to Win, which features five elements: People, Products, Place, Price, and Promotion, focused on the customer3. The five P’s actions make up McDonald’s brand and provide a framework for prioritizing goals. For People, they looked to their customers and understood patterns have changed with more snacking and drive-thru, thus they responded with products like Snack wraps, and a reconfigured drive-thru. The restaurants were renovated or rebuilt, also price and promotion through the dollar menu4.

The Plan to Win is made of three pillars, menu innovation, store renovation, and an upgrade of the ordering experience, which help McDonald’s remain sustainable with their profits. McDonald’s responds to customer’s demands by changing their product line accordingly. When first founded in 1955, they focused on the quality of their products with a limited menu of burgers, fires, and beverages. McDonald’s has shifted this strategy by broadening their product portfolio, with the adaptation of salads and chicken5. Additionally, to compete with Starbucks and local coffee shops, they have launched McCafe, which features high quality coffee drinks.

As well as, invest in their current stores of operations to make a more relaxed environment. They need to maintain a modern environment and stay relevant with food trends. The last pillar is to upgrade the ordering experience, which can be accomplished through technological advances with the drive thru and front counter. They can sustain profitable by following the three-legged stool idea, with all three forces working together and implementing the Plan to Win. As long as, McDonald’s continues to follow their successful strategy of a Plan to Win and the three legged stool their return on equity will not revert to its cost of capital.

Accounting Analysis: The accounting method of McDonald’s is in compliance with GAAP and its financial statements are easily comparable to other firms with similar accounting policies. From McDonald’s financial statements, the key accounting policies include consolidation, revenue recognition, advertising costs, property and equipment, goodwill, and long-lived assets. The consolidated financial statements include company and subsidiaries, and the consolidation is under equity method. A significant part of McDonald’s operating income is generated outside the U.  S, and foreign currency earned by subsidiary is translated to US dollars. McDonald’s revenue recognition consists of sales by Company-operated restaurants and fees from franchised restaurants. The revenue from Company-operated restaurants is recognized on a cash basis. Advertising costs are included in operating expenses and increased steadily from 2010 to 2012. Property and equipment accounts for a large amount in total asset and are depreciated over straight-line basis. McDonald’s goodwill primarily results from purchases of restaurants from franchisees and ownership increases in subsidiaries or affiliates.

Impairment tests are conducted for long-lived asset (include goodwill) every year. 6 Generally speaking, McDonald’s accounting methods reflect the firm’s business reality fairly. However, there is still some degree of accounting flexibility in McDonald’s accounting methods. First of all, property and equipment are depreciated or amortized on a straight-line basis over the estimated useful life. Property and equipment is McDonald’s largest asset (24,677. 2 million out of total asset 35,386. 5 million for 2012), and McDonald’s could vastly overstate or understate income by using a different depreciation method.

Secondly, the impairment practices of long-lived asset also have some flexibility. The amount of goodwill (2804 million for 2012) is substantial. Sometimes the goodwill will become impaired, and the impairment tests McDonald’s adopts will be very important. The company’s depreciation methods and goodwill impairment tests are very important in its financial statements for the numbers are so substantial. Thirdly, McDonald’s also has a lot of flexibility in terms of accounting estimates. McDonald’s adopts GAAP, which requires management to make various assumptions and estimates in different situations.

Since estimation usually involves experience and judgment, the accounting methods could lead to some degrees of difference of estimated numbers and actual results. 7 To sum up, McDonald’s adopts accounting methods that are typical of the fast food service industry. The disclosure explains the accounting choices and estimates in detail, and the footnotes are very understandable. We do not find any skeptical information that was not reasonably explained in McDonald’s disclosures so it is not necessary to undo any distortions or restate the financial statements.

There was no reason to undo any accounting distortions because we did not find any skeptical information that was not explained in their disclosures. Industry Analysis:There are about 200,000 restaurants in the fast-food industry. Generally speaking, this industry is highly labor-intensive and very fragmented. The top 50 fast food companies account for 25% of total sales. Quick-service restaurants operate through different channels such as national and regional chains, franchises, and independent operators. Besides, most quick-service restaurants use a point of sale system to take orders from drive-thru and registers.

Due to the sluggish economic recovery, customers have been cautious about eating at restaurants. To attract more consumers, McDonald’s has to compete with other restaurants through the food quality, variety and customer service. Even though most fast-food restaurants specialize in a few main dishes, they still have to provide customers with a vast variety of products and healthier options to better build their brand images. In the meantime, the fast food industry needs to be convenient and fast to accommodate the fast pace of American lifestyles. 8 Five Forces Analysis: 1.

Rivalry among Firms: As one of the leading companies in the industry, McDonald’s has a lot of competitors such as Wendy’s International, Burger King, Yum Brands Inc. , and Harvey’s. The competition in the quick service food quick-service restaurant is very intense. Even under economic recessions, the market will not shrink as much as other high end restaurants so the fast food industry is growing rapidly. 2. Threat of New Entrants: The threat of new entrants in the fast food industry is high because the barrier to create a quick service restaurant is low. In addition, franchise options make it easier to enter the market.

The accessible distributions are essential among all companies in the industry, but they are not difficult for new entrants to attain. 3. Threat of Substitute Products: Firms among the fast food industry are competition with similar products such as hamburgers, French fries and chicken wings so the threat of substitute products is relatively high. The industry has tried various product differentiation strategies to make their products stand out in the market. For example, McDonald’ has its classic Big Mac, Chicken Nuggets and Happy Meal to differentiate its brand from other fast food restaurants.

Bargaining Power of Customers:Since the switching cost for customers is nearly zero, the firms in the fast food industry have to conform to the society’s needs to retain consumers. For instance, McDonald’s is focusing more on the healthier menu choice to conform to the changing tastes of society. 5. Bargaining Power of Suppliers: The switching cost for fast food restaurants to change suppliers is very low. There are thousands of suppliers in the market for firms to choose from. McDonald’s has a huge bargaining power because it can make up a large portion of the supplier’s revenue.

The barging power of suppliers is very limited. Financial Analysis: McDonald’s has been increasing their revenue and income, however there net profit percentage has been decreasing from 21% in 2010 to 19. 8% in 2012, which shows there expenses are increasing as well. Attached exhibit 1 has all of the numbers and ratios in more detail. Although, the net profit percentage has decreased it is still well above the S & P’s average of 8. 9%. Their large profit percentage can be contributed to the strong relationships with suppliers, by buying products at a lower cost since the quantity is so large.

Over the past five years for McDonald’s they have been issuing a high dividend that started off in 2008 at $1. 63 and in 2012 is at $2. 87, showing that they are a mature company. It is reasonable to assume that people would invest in McDonald’s based off of a dividend of this caliber. 9 The strength of McDonald’s compared to the S & P average is strong, as seen with sales of $27,567 million to the S & P average of $19,937. McDonald’s has high earnings per share at $5. 36 with the average at $3. 19, the different is contributed to the high net profit McDonald’s has.

Additionally, the beta for McDonald’s is low at 0. 38 with the S & P average of 1. 18. This is reasonable considering the industry and brand of the company because they have strong clientele and the food service industry is a need for customers. They have not been successful in all areas of operation. For example, McDonald’s main competitor is Yum! Brands, Inc. who operates franchise, such as KFC and Taco Bell. They have exceeded McDonald’s market share in China. However, Yum! does have a higher beta at 0. 78 compared to McDonald’s of 0. 38, which results in more risk for the company10.

The other competitors for McDonald’s are Wendy’s and Burger King, which still are not comparable in size, as seen in exhibit 3. Wendy’s had sales of $2,505 in 2012 and Burger King had sales of $1,966 in 2012, this shows how much of a larger corporation McDonald’s is in volume. 11 Wendy’s has an extremely high PE ratio of 430. 5, which is attributed to a low EPS of $0. 02. 12 Lastly with regards to McDonald’s financial statements it is important to note their statement of cash flow. As seen in exhibit 4, they have positive operating cash flow, which means they are self-financed.

This has remained consistent throughout the past three years with the most significant changes in their liabilities. They have increased their investing activity from ($3,167,300) in 2012 to ($2,570,900) in 2011. This is associated to the large renovations and new technology that McDonald’s has been implementing in their stores. Also, in the financing section they have continued to be paying a large dividend. Forecasting:We based our forecasts on two principle models; the eVal DataMaker by Lundholm and Sloan, exhibit 5 13 and three condensed models based on those described by Palepu and Healy in “Business Analysis & Valuation” exhibit 6.14 The first condensed model used FY 2012 as a starting point; the second one adjusted for recent trends and the third model used average performance rates from 200 8 to 2012. Data was collected from Morningstar. com and occasionally from McDonald’s financial statements. Several assumptions were made for the expanded forecast, as shown in exhibit 7. The most important being the steady 2-3% annual growth in sales and the flat continuation of the CGS and effective tax growth rates. This ensured a very small but steady growth pattern on the Income Statement.

On the Balance Sheet, working capital is assumed to continue growing at the same rate through 2016 and finally the dividend payout ratio is expected to decrease annually. Similarly modest assumptions were made to the three condensed models with the exception of the model based on trends. Past and current trends were more important for the forecasts than comparisons with other firms. While Burger King, Wendy’s, and Yum brands are all competitors, they have significantly different business models. McDonalds is a much larger firm, it has a greater international presence and it also invests heavily in real estate.

Positive trends affecting the company include; the company’s shift towards healthier foods which should help expand the product line and attract new consumers, and its advances in technology. McDonalds is currently in the test phase for outsourcing drive-thru’s, which should accelerate service and reduce mistakes. The company is also looking to create remote call centers for customer service. 15 Potential negative trends include; international economic stagnation, an increase in local competitors, and negative publicity towards the fast-food industry. In the U. S. , McDonalds has also faced recent backlash for opposing minimum wage increases.

The S&P analysts also predict moderate growth for McDonalds but are slightly more optimistic for 2013 and 2014. They estimate total revenues will increase 2. 4% in 2013 but 5. 1% in 2014. Similarly, they predict growth in the U. S. will be affected by rising employment payrolls. They felt stagnation would not be global but limited to China and other Asian markets. There was also concern for rising food costs and fluctuating international currency rates, which would negatively impact McDonald’s international sales. 16 Other analysts predict 2013 revenue increases of 3. 7%17 and 2. 8%18 and 2014 increases of 7% and 5.3%. Overall, the key strategic drivers are business line expansions and macroeconomic trends and the most important changing metric is future sales. The forecasts and “hold” stock recommendations suggest McDonalds should consider adjusting its’ business strategy. As a company that has the ability to expand/contract rapidly and as a company that invests heavily in real estate, one suggestion might be to focus on building in developing economies. These areas would have rapidly appreciating real estate, access to a relatively cheap workforce, and social environments that might be more amenable to fast food.

In countries, which have embraced health food trends, McDonalds could look at partnering with local farms and use its large economies of scale to offer cheaper local, healthy product options. Valuation: Based on the opinion of S&P, the fair value of McDonald’s is $88. 40. In that way, McDonald’s is slightly overvalued by $8. 97 or 9. 2%. In order to better evaluate the McDonald’s, we use two different valuation models to come up with the value: Discounted Cash Flow and Residual Income Valuation Model. Discounted Cash Flow: The discounted free cash flows model uses WACC to figure out the value. Our WACC for McDonald’s is 0. 07.

The sensitivity analysis indicates that if the growth rate of WACC is changed, the estimate of the price will also change substantially. Under the DCF model, McDonald’s is valued at $69. 2, which indicates that the company is overvalued. Residual Income Valuation Model: The residual income value model sums up the current book value, forecasted residual income for the next 10 years, and the present value of residual income for next 10 years. The present value of the firm was calculated by using our forecasted earnings and dividends. According to the residual income model, McDonald’s is valued at $66. 11 so it is overvalued.

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