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Summary

  • We pitch two companies from the services sector, McDonald’s and Burger King, against one another in the latest instalment of our Head-To-Head series.
  • The article focuses on the relative strengths and weaknesses of McDonald’s and Burger King based on business performance and sustainability/dividends/forecasts.
  • It ends with discussion of the current valuations of the two companies, and details whether McDonald’s represents good relative value at current price levels.

McDonald's Background

McDonald's (NYSE:MCD) was founded in 1940 and is based in Oak Brook, Illinois. It franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada and Latin America. The company's restaurants offer various food items, soft drinks, coffee and other beverages, as well as breakfast menus. As of December 31, 2013, it operated 35,429 restaurants, including 28,691 franchised and 6,738 company-operated restaurants.

Our Rating

Our investment philosophy is to focus on company fundamentals and identify stocks that are displaying strong business performance, that operate sustainably and that pay a decent, well-covered dividend.

We analyze each company relative to the other on the following criteria within each of our two main buckets:

Business Performance

  1. Return on equity
  2. Return on assets
  3. Operating margins

Sustainability/Dividends/Forecasts

  1. Debt to equity ratio
  2. Interest cover
  3. Dividend payout ratio
  4. Forward yield
  5. Annual EPS growth forecast

Once we have analyzed the two companies based on the first two buckets, we can then assess whether they represent good value based on the current prices of the two stocks. We use the following criteria to assess valuations on a relative basis.

Valuation

  1. Forward price to earnings ratio
  2. Price to book value ratio
  3. Enterprise value to EBITDA
  4. Price to 3-year average free cash flow ratio
  5. 5-year price to earnings growth ratio

So, for example, a company that performs well compared to its rival on the first two buckets (business performance and sustainability/dividends/forecasts) and that is undervalued relative to its peer (based on the third bucket: valuation) could outperform its competitor going forward.

The table below provides the data that we will use to analyze McDonald's and Burger King (NYSE:BKW) for the first two buckets.

Stock

McDonald's

Burger King

Business Performance

Return on equity

35.19%

19.01%

Return on assets

15.12%

6.58%

Operating margins

30.23%

56.58%

Sustainability/Dividends/Forecast

Debt to equity ratio

86.25%

198.82%

Interest cover

14.16

2.63

Dividend payout ratio

57.00%

36.00%

Forward dividend yield

3.20%

1.10%

Annual EPS growth forecast

8.19%

16.84%

McDonald's scores well in the first two buckets. Indeed, we're impressed with the company's profitability, with it delivering return on equity of 35.19% and return on assets of 15.12%. Both of these figures are considerably better than those of Burger King, although McDonald's doesn't enjoy the same level of operating margins as its smaller rival, with McDonald's having operating margins of 30.23% and Burger King's operating margins being 56.58%.

However, where McDonald's easily looks more attractive is in terms of balance sheet risk. McDonald's has a moderately high debt to equity ratio of 86.25%; however, its operating profit is more than sufficient to cover it at 14.16 times. However, Burger King appears to be carrying significant amounts of debt on its balance sheet, with its interest cover being fairly slim at 2.63 and its debt to equity ratio being high at 198.82%. In terms of balance sheet strength, McDonald's is by far the more impressive of the two.

Meanwhile, McDonald's offers a better yield (3.2% versus 1.1%), but there is scope for both companies to increase dividends per share as a result of relatively low payout ratios. Furthermore, both companies offer strong growth prospects, although McDonald's is not in the same league as Burger King on this front, with EPS forecast to increase by 8.19% next year versus 16.84% for Burger King.

Overall, a close performance, with McDonald's being the more profitable and less risky, while Burger King offers more growth.

Valuation

Due to their close performance in the first two buckets, we would expect McDonald's and Burger King to trade at similar levels across a range of valuation metrics. Let's see if they do.

Stock

McDonald's

Burger King

Valuation

Forward price to earnings ratio

15.36

23.74

Price to book ratio

5.89

6.12

EV/EBITDA

10.50

17.28

PEG

2.42

1.76

Price to free cash flow ratio

22.39

35.75

We're surprised to see that McDonald's trades as a significant discount on a number of the valuation metrics used in the third bucket: valuation. For instance, McDonald's has a forward P/E ratio that is currently 35.3% below that of Burger King, while its EV/EBITDA ratio is a whopping 39.2% lower than its sector peer. In addition, the two companies' price to free cash flow ratios appear to be at too wide a gap right now, being 22.39 for McDonald's and 35.75 for Burger King. Of course, due to its higher growth rate, the PEG ratio highlights Burger King as the better value of the two. Despite this, we feel that the valuation discounts of McDonald's to Burger King are generally too wide and, as such, we think that McDonald's could outperform Burger King going forward.

Conclusion

McDonald's is a high quality company that posted impressive scores on The Team Money Research Rating System. Although its scores were on a par with sector peer, Burger King, the valuation bucket highlighted that the company appears to offer significantly better value for money at current price levels. As a result, we believe that McDonald's could outperform Burger King going forward.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Why McDonald's Is A Better Investment Than This Key Rival