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Optimal investment decision: a function of preferences, predictions, or facts?

September 6, 2017

 

Investing can be simply illustrated as ordering a meal every day from the same restaurant, made by the same cook, using the same ingredients and equipment, but the food always tastes slightly different than the last time you ordered. You might wonder why this was happening, but there are some evidential facts that are undisputable. When investing, you can do everything right but you may not always get the projected outcome. Sometimes the outcome is good, while other times it is not. There are things an investor can control and there are things that cannot be controlled. One of the things that an investor can control in order to ensure that he or she is making the right investment decision is preference.

 

Here are some important preference questions to consider:

 

  1. Risk Tolerance

     

    On a scale of 1-5, with 1 being low risk and 5 being aggressive, where do you feel the most comfortable?

     

    Example: Stock A has a risk factor of 5, an investment return of 80% in a good market, and a risk of 40% loss in a bad market.

     

    Stock B has a risk factor of 3, an investment return of 20% in a good market, and a risk of 5% loss in a bad market.

     

  2. Time Horizon

     

    How long will you be investing? It is important to be specific when deciding on your time horizon. You want to know how long you will be investing in a particular stock, the particular investment vehicle you will be using, such as a brokerage account, and the investment firm you will go through.

     

  3. Investment Objective

     

    Besides a desire to make money, why are you investing? Some people invest for a short period of time in order to obtain a down payment for a house, while others invest for a long period of time for supplement income when they retire.

 

In order for your investment to be consistent with market efficiency, you should tailor it as needed to reflect your preference.

 

The second way to ensure an investor is making the best investment decision is to be able to predict a stock movement. Stock movement prediction is really an educated guess on the probable outcome of a stock rising or falling based on historical data, which of course does not guarantee future performance. The last and most valuable way to ensure a successful investment strategy is to gather and analyze as many facts as possible. These facts are almost always found in companies’ financials.

 

The bottom line is that the optimal investment decision is a function of preferences, predictions, and facts. When these three components are used strategically, you can decrease the impact of outside factors that might be outside of your control.

 

Let’s take a look at an example of how you can analyze facts about a company which will help you predict, to a degree, the company’s future outcome.

 

To analyze a company’s financials, you want to pull financial data contained in 10-K, 8-K, and annual reports, which can be found on the SEC website. For example, I analyzed McDonald’s financial data for the fiscal year 2013 in relation to fiscal year 2012, 2011, 2010, and then benchmarked this against Wendy’s financial data.

 

McDonald’s overall top line revenue increased (in millions) from $27,567 to $28,106, up 2% YOY in 2013, which means added revenue was (in millions) $539. In comparison, Wendy’s YOY rate declined from (in millions) $2,505 to $2,487 in 2013, a decrease of .7%. This indicates that Wendy’s revenue shrank by (in millions) $18.

 

McDonald’s COGS increased by 2.3% YOY, leading to a slight decrease of gross margin ratio from 44.3% (2012) to 44.1% (2013). The decreased gross margin ratio was offset by a decrease in 2013 SG&A expenses of approximately 2.8% YOY, due to a lower incentive-based compensation, which lead to a higher EBIT, also known as operating profit.

 

McDonald’s EBIT increased by 1.9% YOY, with a slight profit margin ratio increase from 19.8% to 19.9%. Even though EBIT increased YOY for McDonald’s, the EBIT margin ratio remained the same from 2012 to 2013 at 30.3%. High earnings before interest and tax has a direct impact on operating profits. The higher the EBIT, the more profitable the operation. This leads to a positive impact to McDonald’s’ bottom line.

 

Corresponding results for Wendy’s COGS decreased by -2.9% YOY, which led to an increase in its gross margin ratio from 24.9% (2012) to 26.6% (2013), in spite of their SG&A expense increasing by 2.1% YOY. Wendy’s company EBIT margin ratio increased from 7.6% to 9.0%, with an increase in profit margin ratio from 0.3% to 1.8%.

 

Bottom line: Despite Wendy’s strong EBIT and profit changes from 2012 to 2013, McDonald’s surpassed Wendy's in the following areas for the year 2013: sales growth, gross margin ratio, EBIT margin ratio, and profit margin ratio. It is important to highlight that McDonald’s’ financial filings indicate a steady growth from 2009 to 2013.

 

With respect to efficiency measures, McDonald’s has an asset turnover of 0.8, which is better than Wendy’s at 0.6. However, Wendy’s days sales in inventory improved from 2.7 to 2.0, which is better than McDonald’s at 2.9. Note that Wendy’s day sales outstanding remains at 7.6 in 2013. McDonald’s improved days sales outstanding from 18.2 in 2012 to 17.1 in 2013, but this holds no weight in comparison to Wendy’s efficiency data in the same years.

 

When taking a closer look at days payable outstanding, McDonald’s data at 25.2 shows a definitive advantage over Wendy’s data of 16.7. The cash conversion cycle in total for McDonald’s decreased from -6.05 to -5.23, while Wendy’s increased from -3.41 to -7.07.

 

McDonald’s Corporation demonstrates strong performance in the area of management effectiveness. McDonald’s data proves to be significantly better than data of Wendy’s company, and shows McDonald’s solid performance with only a slight decrease in ROA (15.4% to 15.3%), ROE (35.7% to 34.9%) and ROIC (5.5% to 5.3%). McDonald’s numbers are substantially better than Wendy’s ROA (1.0%, improved from 0.2%), ROE (2.4%, improved from 0.4%) and ROIC (3.5%, improved from -3.5%). However, it is noteworthy that the market cap for both companies increased from YOY for McDonald’s, from (in millions) $88,448 to $96,098, and Wendy’s, from (in millions) $1,844 to $3,425.

 

While McDonald’s stock price increased by 10% YOY, Wendy’s recorded a phenomenal stock price increase of 85.5%. Wendy’s stunning stock increase is best explained by the completed sale of 3,600 Arby’s stores. This move generated an impressive $130 million dollars of capital gain for the Wendy’s company. Wendy’s decision to sell Arby’s stores served as a catalyst for attracting investors, leading to high numbers of buying transactions throughout 2012. The financial strength of McDonald’s increased slightly, indicated by McDonald’s current ratio increasing from 1.4 to 1.6. This shows a strong ability to pay off debt with assets. Despite McDonald’s financial strength, the current ratio of Wendy’s was an impressive 2.6, having increased from 2.5 in 2012. Wendy’s company has also shown they can keep an abundance of cash on hand in reserves to pay any debt outstanding or for future growth.

 

With respect to valuation, McDonald’s 2013 market-to-book ratio, also known as P/B ratio, was 6.0, whereas Wendy’s market-to-book ratio was 1.8. Interestingly, Wendy’s had a higher P/B ratio change from 2012 at 0.9, with an increase of 0.9, while McDonald’s was at 5.8, with an increase of 0.2. P/B ratio can be an indicator of an investor’s perception in relation to the company’s business prospects. Despite the major change to Wendy’s P/B ratio YOY, McDonald’s still holds a higher P/B ratio in the marketplace.

 

In 2013, McDonald’s continued to invest through share repurchases, returning $4.9 billion to investors throughout the course of the year. Wendy’s had a mere $99.9 million of dividend payments and repurchased stock in 2013. Despite the numbers, the percentage of free cash flow returned to shareholders over the last five years has been significant and sustained for both companies. Based on an average of 109.3% for McDonald’s and 180.3% for Wendy’s, it is apparent that Wendy’s company returned cash to investors more aggressively than McDonald’s. The 5-year average payout ratio for McDonald’s is 50.8%, in contrast to Wendy’s 5-year average of payout ratio at 187.8%. McDonald’s successfully returned cash to investors and also achieved company expansion. This is illustrated by capital expenditures allocated to new restaurant openings.

 

McDonald’s has continued to grow its margins over the last five years, despite major economic events that may have impacted both firms. In an effort to redefine their brand image and remain relevant in today’s food service industry, McDonald’s has channeled investment dollars towards storefront construction updates. McDonald’s has the potential to make a profound improvement to brand perception by continuing to update the aesthetic of their brick and mortar restaurants.

 

It is commendable that McDonald’s has achieved both significant global sales growth and met their construction goals, while returning significant investments to shareholders through both dividends and share repurchases.
McDonald’s can continue to maintain a positive investor image through the continuation of strong marketing and advertising programs.

 

In summary, McDonald’s stock is a stable buy which still has room to grow, so long as the company continues to invest in opportunities that lead to company expansion, while maintaining management effectiveness and continuing to return cash to investors, lower costs, and increase revenue.

 

 

 

 

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