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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