Legendary investor Warren Buffett once said, "Never invest in a business you cannot understand." This might explain the allure of restaurant stocks -- few businesses are as straightforward as selling food.
Below, we'll look at the five largest restaurant stocks in 2020. However, there are different ways to think about what "largest" means, and unpacking these definitions provide actionable insight for investors.
The largest market caps
When you buy a share of a company's stock, you're buying one of many -- there are typically millions of shares. A company's market capitalization is the value of all these outstanding shares together. If you bought them all up, you'd own the company.
The two restaurant companies with the largest market caps are McDonald's (NYSE:MCD) and Starbucks (NASDAQ:SBUX). McDonald's market cap is around $142 billion, while Starbuck's market cap is $87 billion.
The next three largest restaurant stocks in terms of market cap are Chipotle Mexican Grill (NYSE:CMG), Yum! Brands (NYSE:YUM), and Restaurant Brands International (NYSE:QSR). But interestingly, their market caps don't even come close to those of McDonald's and Starbucks. Somehow, those two companies discovered ways to make their businesses more valuable.
McDonald's is the largest restaurant chain in the world with nearly 39,000 locations. But this isn't how it took the crown for largest restaurant stock by market cap. It may be the largest chain, but it's not the largest restaurant company. That distinction goes to Yum! Brands.
Most total restaurant locations
Yum! Brands owns Taco Bell, Pizza Hut, KFC, and the Habit Burger Grill. Together, it has over 50,000 restaurant locations -- almost 30% more than McDonald's. And yet, McDonald's market cap is five times that of Yum! Brands. How?
Market caps can be measured by things like sales and earnings. For example, a company with a $100 billion market cap and $10 billion in revenue is valued at ten times sales. But not all stocks have the same valuation. Some companies with inferior sales and earnings can achieve a higher market cap by gaining a higher valuation. That's not the case with McDonald's. Yum! Brands and McDonald's trade at identical price-to-earnings ratios and comparable price-to-sales ratios. This means McDonald's somehow generates much higher revenue and earnings, despite having significantly fewer restaurants.
With restaurants, a company's structure plays a big role in its financial potential. For starters, McDonald's owns a good portion of the real estate used by its franchisees. Therefore, the company doesn't just collect its franchise fees, it also collects money as a landlord. Yum! Brands does this, too, but not nearly to the extent McDonald's does.
In the first quarter of 2020, McDonald's collected $1.7 billion in rent alone. For perspective, that's more in rent revenue than Yum! Brands generated in total revenue in Q1. McDonald's makes so much from rent that it accounted for 35% of its total Q1 revenue.
McDonald's also retains a higher percentage of company-owned locations than Yum! Brands. McDonald's is 93% franchised, while Yum! Brands is 98% franchised. This mere six-point difference is extremely significant. McDonald's generated over $2 billion in Q1 revenue from just 2,637 company-owned locations. If it were 98% franchised, like Yum! Brands, it would have fewer than 800 company-owned restaurants, likely missing out on over $1 billion in quarterly revenue.
These two structural differences between McDonald's and Yum! Brands are key. And the difference between a company-owned and franchised structure explains why Restaurant Brands International is only valued at $17 billion. The company has over 27,000 locations if you count its Burger King, Tim Horton's, and Popeyes concepts. But it's approximately 100% franchised.
Most company-owned locations
McDonald's is the largest restaurant stock by market cap, and Yum! Brands is largest in terms of total overall locations. But there's another way to think about this. Starbucks has over 32,000 locations, and the company owns more than 16,000 of them. Therefore, Starbucks owns more restaurants than any other restaurant company.
Going with a company-owned structure can be lucrative. Starbucks has such a high market cap, partly because it's approximately 50% company-owned. Instead of merely collected franchise fees (which are just a small percentage of sales) it's able to retain these sales as revenue. The profit margin on restaurant sales isn't as good as it is with franchise fees. But there's so much more revenue coming in that its net profit is significantly higher, and the company is worth more as a result.
Chipotle takes this ownership model a step further. Of its 2,638 locations, all of them are company-owned. In other words, as of Q1, Chipotle technically owns more restaurants than McDonald's. That's astounding.
A franchise model has its place. McDonald's has certainly made it work and excelled by creatively using the real estate. But when a restaurant concept has high sales volume and is highly profitable, expanding with company-owned locations will unlock significant shareholder value. That's why Chipotle comes in as the third largest restaurant stock by market cap, despite its footprint being much smaller than the other four companies on this list.
As we've seen, not all restaurants are set up the same. Therefore, not all have the same opportunity to reward long-term investors. Understanding the differences can help you be more selective with restaurant stocks. High sales volume, high profit margins, and a large percentage of company-owned locations are all desirable qualities to look for.