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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Building a Small Business That Warren Buffett Would Love

Available Everywhere, March 2012