McDonald's and a Golden Crispy Return on Equity

Painting the Picture of Return on Equity

Simply put, return on equity is a measure of how hard the equity in a business is working.

ROE = Net Income/Shareholder’s Equity

Net income can be found on the income statement and equity can be found on the

balance sheet. In a small business with one owner, all of the equity technically belongs to the single owner or the single shareholder, although technically, shares may not exist depending on the entity type. All things equal, a business investment with a 20 percent return on equity is superior to a business investment with a 10 percent return on equity.

Why So Important?

As you can see from our ROE formula, a business with a strong return on equity is delivering a healthy amount of income using the least amount of equity possible. (The numerator is big, the denominator is small, you put the lime in the coconut.)

Back to our comparison mantra, we don’t necessarily want to throw $100,000 worth of equity into a business generating a 10 percent return on equity, or $10,000 a year, when we can invest it in another available option that is firing at 20 percent a year and will deliver $20,000 a year in income. More is better, right, when it comes to income and business.

For an existing business, a low return on equity is an indicator of a problem. If after obtaining your handy dandy industry comparison report you find that your business should be chopping away at a 15 percent return on equity and it is only delivering 7 percent, I would argue that the competition in town is probably eating your lunch (McNuggets included), and sooner or later they will be eating your dessert as well (Snozzberries!). The competition is utilizing their equity more efficiently, leaving them more income at the end of the year to potentially reinvest and grab more market share. Better start tweaking your return on equity or grabbing those McDonald’s references.

And Now Some Examples

Table 4.1 displays three 10-year track records of three consumer monopoly companies that Warren Buffett was at one time or currently in love with: McDonald’s, Coke, and Wal-Mart. Above all else, this picture should give you a crystal clear expectation of what to look for in order to build a business that Warren Buffett would love. Remember, return on equity is found by dividing the net income, from the income statement, by the equity found on the balance sheet.

Table 4.1 Ten-Year Return on Equity for Three Consumer Monopolies

Source: ProfitCents, reproduced with permission.

McDonald’s: The name alone brings to mind those golden, crispy fries, inexpensive hamburgers, Grimace, Officer Big Mac, Mayor McCheese, the useless McNugget mascots.

Look at that golden, crispy return on equity over the years. Despite a very anemic 2002 at 9 percent, we see a steady, strong march through the mid to upper teens and into the lower 30 percent range in the late 2000s, resulting in a hearty, 10-year average return on equity of 21 percent. Beat that Colonel Sanders! (Author’s note: The squinty eyed, bolo-tie wearing, senior commissioned officer connoisseur of fried poultry has in fact annihilated this number … over the past five years, as part of the Yum brands portfolio, according to Morningstar.com, KFC and its Yum counterparts have averaged a 131 percent return on equity. That’s a lot of chicken!) McDonald’s exemplifies a business with steady, strong, and growing return on equity, one that so far, Warren Buffett would love.

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Coke Polar Bear Goes Crazy ... Over Earnings

When it comes to starting, building, buying or investing in a business, it is imperative to seek out a strong track record of earnings in order to Build a Small Business That Warren Buffett Would Love. Why? Because with consistency comes predictability and with predicabilty comes the assurance that the business can repeat the past and has the potential to increase the overall company value. A business with earnings can potentially retain the earnings and reinvest them in high yielding projects that will continue to increase the overall company earnings and value.

Without predictability, it is difficult to project the future value of the business with any sort of reliability.

What We Want to See

Coke's ten-year earnings per share track record is as follows:

This appears to be a nice and steady, growing earnings record. It appears to be reliable and growing at a 13.7% clip. This is the type of record to seek out in an investment or any type of acquistion or start-up scenario. It might not be on a per share basis, but nonetheless, the pattern should be the same.

As Opposed To ...

This. You do not want to see this. It looks like the track layout of Space Mountain.

Again, the reason this is so important is because well, number one, the company is making money and two, it will now be possible to run valuation formulas as mentioned in the book Building A Small Business That Warren Buffett Would Love and come up with a future value for the business and a present value price tag. Earnings are penultimate in identifying a healthy business that has lasting power.

Again ... this is what we want to see in the earnings picture:

It is the picture of earnings that makes Coke even more delicious and refreshing.

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The Consumer Monopoly

What makes a brand distinctive? Better yet, let's name some distinctive brands:

-McDonald's
-Coke
-Hershey's
-Campbell's

If I say soup, what is the first brand name that comes to mind? For me, this is easy. It is Campbell's. (sorry all of you Progresso folks)

So, for argument's sake, a consumer monopoly is emblazoned in the minds and hearts of consumers. It took Coke years, literally hundreds of years of brand building, positioning itself in tin-type pictures gripped in the mitt of Santa Clause, shoving the red color in your face, and endlessly presenting a curved bottle shaped like a hoop skirt in order to establish its endearing presence.

The reason, that Coke is a consumer monopoly is because, even with unlimited resources, it would be very difficult for you and I to start a soft drink business and competitively take out Coke.

The same goes for Campbell's. Even with a billion dollars, I doubt you or I could start a soup company that could rival Cambpell's within a few years. Again, when I hear "soup", I think of Campbell's and a red and white can.

So qualitatively, a consumer monopoly is a well-established brand, founded on years of brand-building that could not easily disappear from the hearts and minds of consumers and could not easily be competitively replicated.

This as opposed to a commodity type business ... a business that has no brand distinction. The classic example that I like to use is a gas station. Even if I am loyal to Joe's gas station and like the sandwiches that Joe fixes at lunch, if Bob's across the street starts offering gas for 25 cents cheaper, I will immediately abandon Joe's. In the consumer monopoly scenario, even if Pepsi started offering cans for 25 cents cheaper, I doubt I would abandon my Coke. The same goes for Campbell's soup. Even if Progresso offered a more price conscious soup, I would find it hard to abandon Cambpell's Chicken Noodle.

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The CFO

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CFO'S PLACE IN THE CORPORATION

Years ago, Chief Executive Officers (CEOs) were satisfied with finance chiefs who
could manage Wall Street analysts, implement financial controls, manage initial public
offerings (IPOs), and communicate with the Board of Directors-who, in short,
possessed strong financial skills. However, in today's business environment, the ability
to change quickly has become a necessity for growth, if not for survival. CEOs are
no longer satisfied with financial acumen from their CFOs. They are demanding more
from their finance chiefs, looking instead for people who can fill a multitude of roles:
business partner, strategic visionary, communicator, confidant, and creator of value.
This chapter addresses the place of the CFO in the corporation, describing how to fit
into this new and expanded role.

FIRST DAYS IN THE POSITION

You have just been hired into the CFO position and have arrived at the offices of your
new company. What do you do? Though it is certainly impressive (to you) to barge in
like Napoleon, you may want to consider a different approach that will calm down your
new subordinates as well as make them feelthat you are someone they can work with.
Here are some suggestions for how to handle the critical first few days on the job:

Meet with employees. This is the number-one activity by far. Determine who the
key people in the organization are and block out lots of time to meet with them.
This certainly includes the entire management team, but it is even better to build
relationships far down into the corporate ranks. Get to know the warehouse manager,
the purchasing staff, salespeople, and engineers. Always ask who else you
should talk to in order to obtain a broad-based view of the company and its problems
and strengths. By establishing and maintaining these linkages, you will have
great sources of information that circumvent the usual communication channels.

Do not review paperwork. Though you may be tempted to lock yourself up in an
office and pore through management reports and statistics, meeting people is the
top priority. Save this task for after hours and weekends, when there is no one on
hand to meet with.

Wait before making major decisions. The first few months on the job are your
assigned "honeymoon period," where the staff will be most accepting of you. Do
not shorten the period by making ill-considered decisions. The best approach is
to come up with possible solutions, sleep on them, and discuss them with key
staff before making any announcements that would be hard to retract.

Set priorities. As a result of your meetings, compile an initial list of work priorities,
which should include both efficiency improvements and any needed departmental
restructurings. You can communicate these general targets in group
meetings, while revealing individual impacts on employees in one-on-one meetings.
Do not let individual employees be personally surprised by your announcements
at general staff meetings-always reveal individual impacts prior to
general meetings, so these people will be prepared.

Create and implement a personnel review system. If you intend to let people go,
early in your term is the time to do it. However, there is great risk of letting strong
performers go if you do not have adequate information about them, so install a
personnel review system as soon as possible and use it to determine who stays
and who leaves.

The general guidelines noted here have a heavy emphasis on communication, because
employees will be understandably nervous when the boss changes, and you can do a
great deal to assuage those feelings. Also, setting up personal contacts throughout the
organization is a great way to firmly insert yourself into the organization in short order
and makes it much less likely that you will be rejected by the organization at large.

SPECIFIC CFO RESPONSIBILITIES

We have discussed how to structure the workday during the CFO's initial hiring period,
but what does the CFO work on? What are the primary tasks to pursue? These targets
will vary by company, depending on its revenue, its industry, its funding requirements,
and the strategic intentions of its management team. Thus, the CFO will find that
entirely different priorities will apply to individual companies. Nonetheless, some of
the most common CFO responsibilities are:

Pursue shareholder value. The usual top priority for the CFO is the relentless
pursuit of the strategy that has the best chance of increasing the return to shareholders.
This also includes a wide range of tactical implementation issues
designed to reduce costs.

Construct reliable control systems. A continuing fear of the CFO is that a missing
control will result in problems that detrimentally impact the corporation's
financial results. A sufficiently large control problem can quite possibly lead to
the CFO's termination, so a continuing effort to examine existing systems for
control problems is a primary CFO task. This also means that the CFO should be
deeply involved in the design of controls for new systems, so they go on-line with
adequate controls already in place. The CFO typically uses the internal audit staff
to assist in uncovering control problems.

Understand and mitigate risk. This is a major area of concern to the CFO, who is
responsible for having a sufficiently in-depth knowledge of company systems to
ferret out any risks occurring in a variety of areas, determining their materiality
and likelihood of occurrence, and creating and monitoring risk mitigation strategies
to keep them from seriously impacting the company. The focus on risk
should include some or all of the following areas:

- Loss of key business partners. If a key supplier or customer goes away, how
does this impact the company? The CFO can mitigate this risk by lining up
alternate sources of supply, as well as by spreading sales to a wider range
of customers.

- Loss of brand image. What if serious quality or image problems impact a
company's key branded product? The CFO can mitigate this risk by implementing
a strong focus on rapid management reactions to any brand-related
problems, creating strategies in advance for how the company will respond to
certain issues, and creating a strong emphasis on brand quality.

- Product design errors. What if a design flaw in a product injures a customer,
or results in a failed product? The CFO can create rapid-response teams with
preconfigured action lists to respond to potential design errors. There should
also be product design review teams in place whose review methodologies
reduce the chance of a flawed product being released. The CFO should also
have a product recall strategy in place, as well as sufficient insurance to cover
any remaining risk of loss from this problem.

- Commodity price changes. This can involve price increases from suppliers or
price declines caused by sales of commodity items to customers. In either
case, the CFO's options include the use of long-term fixed-price contracts, as
well as a search for alternate materials (for suppliers) or cost cutting to retain
margins in case prices to customers decline.

- Pollution. Not only can a company be bankrupted by pollution-related lawsuits,
but its officers can be found personally liable for them. Consequently,
the CFO should be heavily involved in the investigation of all potential pollution
issues at existing company facilities, while also making pollution
testing a major part of all facility acquisition reviews. The CFO should also
have a working knowledge of how all pollution-related legislation impacts
the company.

- Foreign exchange risk. Investments or customer payables can decline in value
due to a drop in the value of foreign currencies. The CFO should know the
size of foreign trading or investing activity, be aware of the size of potential
losses, and adopt hedging tactics if the risk is sufficiently high to warrant
incurring hedging costs.

- Adverse regulatory changes. Changes in local, state, or federal laws-ranging
from zoning to pollution controls and customs requirements-can hamstring
corporate operations and even shut down a company. The CFO should be
aware of pending legislation that could cause these changes, engage in lobbying
efforts to keep them from occurring, and prepare the company for those
changes most likely to occur.

- Contract failures. Contracts may have clauses that can be deleterious to a
company, such as the obligation to order more parts than it needs, to make
long-term payments at excessive rates, to be barred from competing in a certain
industry, and so on. The CFO should verify the contents of all existing
contracts, as well as examine all new ones, to ensure that the company is
aware of these clauses and knows how to mitigate them.

- System failures. A company's infrastructure can be severely impacted by a
variety of natural or man-made disasters, such as flooding, lightning, earthquakes,
and wars. The CFO must be aware of these possibilities and have disaster
recovery plans in place that are regularly practiced, so the organization
has a means of recovery.

- Succession failures. Without an orderly progression of trained and experienced
personnel in all key positions, a company can be impacted by the loss
of key personnel. The CFO should have a succession planning system in place
that identifies potential replacement personnel and grooms them for eventual
promotion.

- Employee practices. Employees may engage in sexual harassment, steal
assets, or other similar activities. The CFO should coordinate employee training
and set up control systems that are designed to reduce the risk of their
engaging in unacceptable activities that could lead to lawsuits against the
company or the direct incurrence of losses.

- Investment losses. Placing funds in excessively high-risk investment vehicles
can result in major investment losses. The CFO should devise an investment
policy that limits investment options to those vehicles that provide an appropriate
mix of liquidity, moderate return, and a low risk of loss (see Chapter 13,
Investing Excess Funds).

- Interest rate increases. If a company carries a large amount of debt whose
interest rates vary with current market rates, then there is a risk that the
company will be adversely impacted by sudden surges in interest rates. This
risk can be reduced through a conversion to fixed interest-rate debt, as well
as by refinancing to lower-rate debt whenever shifts in interest rates allow
this to be done.

Link performance measures to strategy. The CFO will likely inherit a company-wide
measurement system that is based on historical needs, rather than the
requirements of its strategic direction. He or she should carefully prune out those
measurements that are resulting in behavior not aligned with the strategic direction,
add new ones that encourage working on strategic initiatives, and also link
personal review systems to the new measurement system. This is a continuing
effort, since strategy shifts will continually call for revisions to the measurement
system.

Encourage efficiency improvements everywhere. The CFO works with all
department managers to find new ways to improve their operations. This can be
done by benchmarking corporate operations against those of other companies,
conducting financial analyses of internal operations, and using trade information
about best practices. This task involves great communication skills to convince
fellow managers to implement improvements, as well as the ability to
shift funding into those areas needing it in order to enhance their efficiencies.

Clean up the accounting and finance functions. While most of the items in this
list involve changes throughout the organization, the CFO must create an ongoing
system of improvements within the accounting and finance functions-otherwise
the managers of other departments will be less likely to listen to a CFO who
cannot practice what he preaches. To do this, the CFO must focus on the following
key goals:

- Staff improvements. All improvement begins with the staff. The CFO can
enhance the knowledge base of this group with tightly focused training, cross-training
between positions, and encouraging a high level of communication
within the group.

- Process improvements. Concentrate on improving both the accuracy of information
that is released by the department as well as the speed with which it is
released. This can be accomplished to some extent through the use of
increased data-processing automation, as well as through the installation of
more streamlined access to data by key users. There should also be a focus on
designing controls that interfere with core corporate processes to the minimum
extent possible while still providing an adequate level of control. Also,
information should be provided through simple data-mining tools that allow
users to directly manipulate information for their own uses.

- Organizational improvements. Realign the staff into project-based teams that
focus on a variety of process improvements. These teams are the primary
implementers of process changes and should be tasked with the CFO's key
improvement goals within the department.

Continues...

---

Excerpted from The New CFO Financial Leadership Manual
by Steven M. Bragg
Copyright © 2003 by Steven M. Bragg.
Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

---

Show Less

Table of Contents

	Acknowledgments
	About the Author
Pt. 1	Overview
Ch. 1	CFO's Place in the Corporation	3
Ch. 2	Financial Strategy	13
Ch. 3	Tax Strategy	39
Ch. 4	Information Technology Strategy	52
Pt. 2	Accounting
Ch. 5	Performance Measurement Systems	63
Ch. 6	Control Systems	88
Ch. 7	Audit Function	104
Ch. 8	Reports to the Securities and Exchange Commission	114
Pt. 3	Financial Analysis
Ch. 9	Cost of Capital	131
Ch. 10	Capital Budgeting	145
Ch. 11	Other Financial Analysis Topics	157
Pt. 4	Funding
Ch. 12	Cash Management	175
Ch. 13	Investing Excess Funds	184
Ch. 14	Obtaining Debt Financing	188
Ch. 15	Obtaining Equity Financing	203
Ch. 16	Initial Public Offering	221
Ch. 17	Taking a Company Private	239
Pt. 5	Management
Ch. 18	Risk Management	247
Ch. 19	Outsourcing the Accounting and Finance Functions	258
Ch. 20	Operational Best Practices	277
Ch. 21	Mergers and Acquisitions	300
Ch. 22	Electronic Commerce	334
Pt. 6	Other Topics
Ch. 23	Employee Compensation	345
Ch. 24	Bankruptcy	351
Pt. 7	Appendices
App. A	New CFO Checklist	365
App. B	Performance Measurement Checklist	371
App. C	Due Diligence Checklist	387
	Index	395

Building a Small Business That Warren Buffett Would Love

Building a Small Business That Warren Buffett Would Love ... available Spring, 2012

The Five Buckets of Analysis

• Base-case analysis
• What-if analysis
• Breakeven analysis
• Optimization analysis
• Risk analysis

Base Case - the common point. Everything is relative to this comparison.

What-if - also known as sensitivity analysis. Assesses the change in outputs associated with a given change in inputs.

Break-even - just how it sounds. The threshold that is crossed from not making a profit to making a profit.

Optimization- explains what variables achieve the best possible value of an output.

Risk Analysis- using probability models to determine the uncertainty associated with a decision.

Building a Small Business That Warren Buffett Would ... available Spring, 2012

CFO

1. Linear Regression = sum of the square of least deviations ... essentially, linear regression can be used to make a straight line forecast. In excel this the forecast function which uses x as the value you want to predict, known xs and known ys.
2. Break-even and break-even dollars. BE = FC / 1 - (VC/S) ... BE units = FC / (unit sales price - unit variable costs).
3. NPV and IRR calculations are necessary for project decisions.

The Subprime Mortgage Crisis

When it comes to the subprime lending crisis, I tend to lean towards and Occam's Razor theory ... the simplest answer is usually the right one. Folks bought more house than they could afford yet banks had become decoupled from their customers as far as mortgage loans go. Back in the It's a Wonderful Life, George Bailey days, when the Savings and Loan made you a mortgage loan, the bank typically held the mortgage for the term of the loan ... 15 years for a 15 year mortgage, 30 for a 30. The standard for banks nowadays is to package the loans up and get rid of them soon after origination. Thus, it doesn't matter so much as to the quality of the loan but as to "how many of these can we do so we can make a quick profit."

To me, this is the heart of the problem. If the local savings and loan has no vested interest as to the quality of the loan then potentially, the quality of the loans will be substandard.

A Global Financial Tailspin

If a penalty is not present for those who take a risk and fail, what disincentive do they have to not try the risky maneuver again? I am a hands-off, deregulation man myself but after reading some of these articles and gaining an understanding of what went on, I think that if any regulation is needed it is in the bond market.

The stock market is fairly translucent, the bond market is opaque. This is what allowed the bond institutions to package up all of the junky mortgages and get them reclassified at a better rating. This was not the cause of the subprime mortgage catastrophe, but it certainly made it worse.

I believe it shouldn't be allowed to get to the point of failure in the first place, at least not on such a massive level based on a massive bet that was founded on unethical financial practices.

The more I read about this the more I come to understand that what happened in the secondary markets, the rolling of the bad loans into tranches which were then rolled into CDOs to mask the bad loans which were then insured with credit default swaps, it was like "Dumb and Dumber Go to a Casino." The problem is, they were having fun making these high stakes, ludicrous bets with billions of dollars. I find it hard to believe that a few key individuals could have been responsible for throwing us into a global, financial tailspin but the more I read, the more I believe this to be the case.

I believe in capitalism and free markets but when a few key players have the power to destroy the free market and opportunity for others, a referee must step in.

Festering Junk and the Law of the Few

I always thought it was a bit too simplistic to say that "greed" was one of the major causes of the massive, subprime financial failure, but the more I read about it ... it is apparent that greedy folk are abound on this planet. (And I don't mean greed as it applies to achievement. To me these are diametrically opposite beasts.) One article I read details the speech of a banker admitting that free checking is a "tax on poor people" because they, the bank's, counted on collecting fees through overdrafts and add-ons.

The sub-prime mortgage market allowed investors to tap into the largest asset base in the states, the home, and although one of the supposed key tenets was to allow home-owners to tap into cheaper interest money, it was like handing a loaded gun to a four-year old.

And then you enter the genius and stupidity of Wall Street. The genius side of the coin (which could arguably still be placed on the stupid side of the coin) came from the folks who invented the subprime mortgage tranches, credit default swaps and the "geniuses" at Goldman Sachs who came up with the CDOs. My understanding is that the tranches and CDOs were ways to hide the junk, B- mortgages mixed in with the not so blatantly, festering junk. The bond tranches were set up like a parking garage (house of cards or stack of dominoes, your pick) with the riskier, substandard loans on the bottom and the better ones on top. The folks on the bottom received the highest interest rates but got wiped out first. Yayyy.

Enter the Genius of Goldman Sachs.

To further mask just how crappy these bonds were, Goldman Sachs started using the CDO or collateralized debt obligation which is essentially subprime bond towers (tranches) within a tower ... or in other words and even bigger house of cards.(stack of dominoe’s etc.)

At this point I would argue that the financial world might not have been devastated by a nuclear bomb had things stopped here but ...

Enter the Genius of Those Who Caught On ...

At this point if you were privy enough to realize just how big the subprime market was ...

“Thirty billion dollars was a big year for subprime lending in the mid 1990s. In 2000 there had been $130 billion in subprime mortgage lending and 55 billion dollars’ worth of those loans had been repackaged as mortgage bonds. In 2005 there would be $625 billion in subprime mortgage loans, $507 bilion of which found its way into mortgage bonds. Half a trillion dollars in subprime mortgage - backed bonds in a single year.” - Lewis, p 23.

And where it was headed, you might just start betting against the subprime mortgage market.

Enter the Credit Default Swap

A credit default swap is essentially insurance on a mortgage bond, insuring against default. The trick is, banks weren't buying them, they were selling them! The individual holding the default swap stood to gain massively if the subprime mortgage market imploded in on itself. Selling a default swap just meant extra income via the insurance premium to the seller.

Enter the Stupidity of AIG

AIG, through the wrangling and tactics of Golman Sachs began selling these things by the bucketfuls and by bucketfuls I mean billion dollar buckets. AIG was taking the other side of the bet and as long as the bank that held the original bond did not collapse, the person who bought credit default swaps stood to gain massively.

I would argue that a few key individuals truly turned a financial crisis into a global thermal nuclear financial meltdown. Had the credit default swap market not have taken off (e.g. those that wanted to buy essentially built the market by talking the banks into building and selling credit default swaps) and the insurers (AIG) not been so blind as to sell these things, I doubt we would still be experiencing the implosion of the housing market today.

In keeping with Malcolm Gladwell's proposition of the "Law of the Few" in which "the success of any kind of social epidemic is heavily dependent on the involvement of people with a particular and rare set of social gifts,"¹ as detailed in The Tipping Point, I would argue that the exacerbation of the financial crisis was caused by a few key individuals.

1.Gladwell, p 33.