Capital is the cash obtained through some form of financing. The two primary ways that companies finance operations are with debt and equity. Depending on the nature of the business, some companies may require more debt than equity, or vice versa.
Capital is a critical component of growing business operations. It is what keeps everything flowing. That said, raising capital isn’t just for companies going through hard times. Capital is also required by successful companies looking to grow. Companies also use debt to buy back stock or pay dividends.
Analysts have mixed views on the use of debt to buy back company stock. Some believe it is a good use of debt at low-interest rates, while others believe companies have taken on too much debt due to a prolonged period of low-interest rates. While there’s nothing wrong with debt, especially at optimal levels, too much of it can greatly increase the risk associated with company earnings. This is why analysts look at trends in measures of market capitalization, debt capitalization, and enterprise value to assess the capital structure of a firm.
Below is a look at the capital structure of McDonald's (MCD).
Equity and Debt Capitalization
McDonald's shares were trading at around $197.61 as of Dec. 31, 2019. The number of shares outstanding dropped from 986 million at the end of 2014 to 765 million by the end of 2019, while market capitalization increased from $90 billion in 2014 to $152 billion in 2019. This is an ideal situation for investors, as it means that the market value of the company’s equity has gone up, but at what cost?
Total debt more than tripled over the same time period that market capitalization increased. Long-term debt increased by approximately $32 billion, from $15 billion on Dec. 31, 2014, to $47 billion on Dec. 31, 2019. Between 2014-2016, McDonald's bought back millions of shares in a stock buyback program, which reduced the total number of shares outstanding.
Enterprise value (EV), also known as a takeover price, is calculated by adding the market cap plus all debt minus any cash and cash equivalents. Unlike market capitalization, which only looks at price and shares outstanding, enterprise value takes the company’s debt capital into consideration.
McDonald's has an enterprise value of $195 billion as of Q4 2019, compared to a market capitalization of $152 billion. The difference between the two is the company’s debt and cash.
The Bottom Line
McDonald's enterprise value has gone up significantly. This is because of a large increase in debt, which was used to pay for billions of dollars in share repurchases and billions more in dividends paid out to investors. It does not, however, mean that McDonald’s is over-capitalized or in trouble. It means that the price of money is still very low and companies such as McDonald's are using this cheap capital to repurchase shares and pay dividends while sitting on large amounts of cash.
Debt increased considerably over the last few years, but the rates on debt are still so low that the hurdle rate required to make the investment in shares profitable is minimal. Companies, such as McDonald's, which believe that its stock is going up in the future, view the purchase of shares with the use of cheap debt to be a good investment. Unfortunately, only time will tell if this is a good capital investment strategy. Investments are only good until they aren't.