Yum! Brands, Inc. (NYSE:YUM) is a better comparison, and that company only managed a 28.75% gross margin in the current quarter. Looking at a few of the faster growing chains, Panera Bread’s gross margin is 34.52% and Chipotle’s is 24.57%. As you can see, anywhere near its price range, McDonald’s gross margin far outstrips the competition.
McDonald’s higher gross margin leads to significant free cash flow, and by one measure, no other company does better. In the current quarter, McDonald’s generated an estimated $0.14 of free cash flow per dollar of sales. Since McDonald’s didn’t provide an actual cash flow statement, this is based on the company’s net income, plus normal depreciation, minus the company’s last quarter capital expenditures. Using the same measure, Yum Brands generated $0.10 of free cash flow per dollar of sales. By comparison, Starbucks generated $0.09 of free cash flow, Panera generated $0.04, and Chipotle generated $0.03.
What About Valuation?
Another reason some investors avoid companies like McDonald’s is their valuation. Amateur investors use the PEG ratio, and see that McDonald’s PEG is higher than many of their competitors. However, the PEG ratio is incomplete when you are looking at dividend paying companies. What I prefer to use is the PEG+Y ratio. This ratio, which was introduced to me by Peter Lynch’s books, adds the company’s growth rate to their dividend, and divides by the P/E ratio. Think of this number as an inverted PEG ratio, and remember the higher the better.
Many would choose Chipotle or Yum Brands over McDonald’s based on PEG ratio. However, using PEG+Y, the numbers change a bit. McDonald’s PEG+Y is 0.75 from the following calculation (8.89% growth rate + 3.28% yield = 12.17% total return / 16.22 P/E = 0.75). Chipotle’s PEG+Y ratio is 0.66 and YUM Brands ratio is 0.68. As you can see, even though Chipotle and Yum Brands are expected to grow faster, they are relatively more expensive.
Starbuck’s PEG+Y is 0.80 and Panera Bread’s is 0.84, which are both better than McDonald’s, but they both rely on faster earnings growth rates to achieve these results. If either chain fails to grow as fast as analysts expect, their ratios would drop.
McDonald’s higher yield, better free cash flow generation, and history of raising the dividend makes the choice more difficult than it first appears. The bottom line is, investors need to be careful to not assume a “boring” blue-chip doesn’t belong in their portfolio. Sometimes the most boring businesses can be the most exciting investments.
The article This Stock Isn’t as Expensive as it Appears originally appeared on Fool.com and is written by Chad Henage.
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