Capital is the cash obtained through some form of financing. The two primary ways that companies finance operations are with debt and with 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, by ensuring that employees and vendors are paid on time. That said, raising capital isn’t just for companies going through hard times. Capital is also required by successful companies looking to employ an acquisition growth strategy. 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 McDonald's Corporation (NYSE: MCD). Each measure provides insight about McDonald’s capital structure compared to other companies in the fast food business, especially those that own real estate.
McDonald's shares were trading at around $165 in Q3 2018. The number of shares outstanding dropped from 1.0 billion in Dec. 2014 to .78 billion in 2018, while market capitalization increased from $90.2 billion in 2014 to $127.5 billion in 2018. 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 nearly doubled over the same time period that market capitalization increased. The increase is due to bond issuance. Debt from bonds increased by approximately $12.0 billion, from $16.7 billion in 2014 to $29 billion in 2018. At the same time, the company re-purchased tens of millions of shares in a stock buyback program, which reduced the total number of shares outstanding.
Trends in Enterprise Value
Enterprise value (EV), also known as a takeover price, is calculated by adding the market value of common stock to the market value of preferred equity, and the market value of debt and minority interest, and then subtracting cash and investments. Unlike market capitalization, which only looks at price and shares outstanding, enterprise value takes the company’s debt capital into consideration.
MCD has an enterprise value of $156 billion as of Q3 2018, compared to a market capitalization of $127.5 billion. The difference between the two is the company’s debt, which is valued at just under $29 billion, and the company’s cash, which is valued at $2.5 billion. In 2018, cash is approximately at the same level as it was in 2014.
Despite a run-up in debt, MCD's enterprise value has gone up significantly. This is because the debt 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 in 2018 compared to 2014, 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 MCD, which believe that their 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.