The return on equity, or ROE, figures for Chipotle Mexican Grill, (CMG 1.22%), Yum! Brands, (YUM 0.56%), and McDonald's Corporation (MCD -0.28%) may seem simple: a bigger return is better, right? Not so fast, you've gotta dig a bit to really understand where that ROE percentage comes from.
Simple(ish)
On the surface, when we look at ROE we see that it's a simple calculation that divides net income by shareholder's equity. Some investors may choose to look at the return on common equity (net income minus preferred dividends/common equity), while other folks may calculate ROE by dividing net income by average shareholders' equity. For our purposes, though, this article will rely on the ROE calculations of Morningstar and it will use the percentages therein.
Through the looking glass
No matter which ROE equation you chose to use, the end result isn't as simple as stating that a higher percentage equals higher value, as we have a bit more to consider when we arrive at that number. In general, the percentage of debt that a company takes on reduces the percentage of shareholder equity. So a company could have a high return on equity, but it could still be quite leveraged, and vice versa.
Digesting the numbers
Yum! had a pretty high return on equity of 50.51% for 2013, but that's nothing compared to what it had in the six prior years. These percentages pretty much coincide with the total debt load that Yum! has chosen to take on. McDonald's return on equity has stayed pretty steady for the last few years, hovering between 30% and 40%. Its debt has been hanging out in that range as well.
Source: Morningstar
As it turns out, fast-food giants Yum! Brands and McDonald's have leveraged themselves up, and this works both for and against them. As they have taken on so much debt both companies have the funds they need to expand their global operations, but in doing so they have taken on a great deal of risk. As of now, these moguls are doing alright in regard to managing their operations in a profitable manner, but the risk of relying on debt in order to stay afloat is ever-pressing.
As investors, we'd be wise to question just how long Yum! and McDonald's can sustain meaningful growth especially in light of the emergence of conscious-consumption trends that center around leading healthy lifestyles. While they have potential for massive growth in emerging markets, both Yum! and McDonald's are inherently risky buys when we consider that each company's supply chain is quite vulnerable to disease contamination and consumer push-back.
Source: Morningstar
Winner, winner Chipotle dinner
Now consider Chipotle, a company with no debt and an ROE of just around 23.5%. Sure, its ROE looks low in comparison with the likes of Yum! and McDonald's, but the lack of debt decreases the burrito maker's risk and ensures that the company isn't biting off more than it can chew. Sure, if it took on some debt Chipotle would be able to expand its operations. However, the company has opted for a more cautious approach by staying slow and steady in its growth.
Your call
Ultimately, shareholders have to decide which risks they are willing to take on. They can invest in a company that takes on a great deal of debt to expand at a rapid pace, or they can invest in a company that stays out of debt and embraces slower growth. Which tactic is appropriate for your portfolio: that of the sustainably minded Chipotle tortoise, or that of the massive growth, massive debts, and massive risks of the Yum! and McDonald's hares?
