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Fast Food Free-For-All! Who Has The Strongest Dividend: McDonald's Or Yum Brands?

February 26, 2014

There are a lot of things that one must consider prior to buying stock in a publicly-traded company. Some of these things include the strength of a company's business model, geographic diversification, financial condition, valuation, and earnings growth.

Another important concern is the dividend that the company in question pays out. Strength and sustainability of the dividend are very important for dividend growth investors. In fact, did you know that 42% of the total return of the S&P 500 over the last 80+ years came from dividends? This is why dividends are so important for any investment portfolio.

Today, let's dig into the fast-food restaurant sector and check out the dividends from McDonald's and Yum Brands. We will look into the dividend history of each company, its historical dividend growth rates, whether or not each company's dividend is supported by cash flows, and whether the companies can sustain their dividend growth rates in the future.

Dividend Yield

When talking about a company's dividend, the first thing that normally comes to mind is the dividend yield, which is the percentage of your capital that you receive in return over the next 12 months, as long as the dividend amount is not changed. Here are the dividend yields from both McDonald's and Yum Brands.

McDonald's 3.4%
Yum Brands 2.0%

 

Table 1: Dividend Yields Of McDonald's and Yum Brands

McDonald's is the clear winner in this category, with a dividend yield of 3.4%, well above the 2.0% currently being offered by Yum Brands. It should also be mentioned that the dividend yield of McDonald's is at its highest point since December 2009, four years ago.

Dividend Growth

The dividend yield is just one of many factors that need to be considered when it comes to the strength of a company's dividend. A company's stock can have a high dividend yield due to an unsustainable dividend payout ratio, or poor fundamentals that have brought down the stock price. These items could then lead to a dividend cut, which will reduce your yield on cost.

Dividend growth should also be considered. This is because a company that increases its dividend payout every year maintains the purchasing power of the income streams that are received by its investors. If dividend growth rates can't keep up with inflation, then investors are really losing money when they consider the loss in purchasing power. Dividend increases also signal a strong outlook by management and underscores their commitment to shareholders. Many companies regard their dividends as a sacred cow. Over time, dividend growth can supercharge an investor's yield on cost. Consider Warren Buffett, who started buying Coca-Cola back in the '80s. Now, he receives a yield on cost of 40%, and growing every year as long as Coca-Cola keeps increasing their payout. Sounds like a pretty good deal, no?

Let's see how the dividends of McDonald's and Yum Brands have grown over the last 5 years. The numbers in the table represent the average dividend growth rate over the last five years.

McDonald's 10.2%
Yum Brands 14.3%

 

Table 2: Five-Year Dividend Growth Rates of McDonald's and Yum Brands

Both of these companies have shown outstanding dividend growth rates over the last five years, easily outpacing the erosive effects of inflation. However, Yum Brands comes out on top here with an average annual growth of more than 14%. Yum Brands has increased its dividend every year for the last 10 years. McDonald's has increased its dividend for 38 years straight.

We should also take note of the fact that while the 5-year dividend growth rate of McDonald's is north of 10%, the company's most recent dividend increase was just 5.2%. The most recent dividend increase of Yum Brands was 10.4%.

These strong dividend histories could not have happened without each company's exceptionally strong business models and brand strength. For right now, Yum Brands is the winner, when looking at dividend growth over the last five years.

Dividend Payout Ratio

High dividend yields and strong growth rates are all well and good, but we need to make sure that the company in question is making enough money to keep the dividends going. This is where the dividend payout ratio comes in. The payout ratio is the percentage of the company's profits that get returned to shareholders in the form of dividends. You usually like to see this ratio at 60% or below, as that will insure that the dividends will continue to get paid, even if the company experiences a downturn over a short period. Dividend payout ratios that approach or exceed 100% may signal future dividend freezes or cuts, which are not good at all for investors.

The table below shows the dividend payout ratios for McDonald's and Yum Brands, both on a trailing twelve month and a four-year average basis. The earnings that I used in these calculations are referred to as core earnings, which remove one-time items that don't have an impact on the company's operations.

Company TTM 4-Year Average
McDonald's 56% 52%
Yum Brands 45% 37%

 

Table 3: Dividend Payout Ratios of McDonald's and Yum Brands

From the looks of Table 3, the dividend payments of both McDonald's and Yum Brands are in very good shape. None of them appear to be in any danger of getting cut. The current payout ratios are a little bit above the four-year averages.

While both companies are looking very good in this category, Yum Brands is just a little bit better here, with a lower payout ratio, both on a trailing 12-month basis and a 4-year average basis. This means that Yum Brands is currently showing more potential for dividend increases in the future. It should also be noted that Yum Brands is targeting a payout ratio of between 35% and 40% of earnings. This is also good, as this will leave more money for the company to plow back into its business.

How About That Free Cash Flow?

A lot of folks would end their analysis after calculating the dividend payout ratio. However, we need to keep in mind that that figure is based on dividend payout as a percentage of earnings, not actual cash that comes into the business over a certain period of time. Earnings often contain items like depreciation, asset impairments, actuarial gains on pension plans, and other non-cash items that can distort the picture as to how healthy a company's dividend really is. For this reason, I like to calculate the free cash flow payout ratio, which shows us what percentage of cash that comes in over a 12-month period gets distributed to shareholders. This paints a more accurate picture when it comes to the dividend safety of the company in question.

Table 4 shows how much of the free cash flows of McDonald's and Yum Brands were paid out in dividends. Note that free cash flow is calculated as operating cash flow, subtracted by capital expenditures. Trailing 12-month and four-year average figures are shown.

Company TTM 4-Year Average
McDonald's 72% 66%
Yum Brands 56% 44%

 

Table 4: Free Cash Flow Payout Ratios of McDonald's and Yum Brands

Here, we see that the dividends that are currently coming from each company are more than well-supported. With that said, the current free cash flow payout ratio of McDonald's is a bit elevated. With the free cash flow payout ratio in the 70% area, I would expect to see the dividend growth of McDonald's continue to moderate in the years to come unless the company can show some growth in free cash flow.

Yum Brands on the other hand, looks really good here, with a lower free cash flow payout ratio that shows more potential for dividend growth going forward.

When it comes to the free cash flow payout ratio, Yum Brands is the winner here.

Any Ways To Predict Dividends Going Forward?

A lot of folks would end their analysis here, especially after looking at the free cash flow payout ratios. However, these figures are all based on what happened in the past. We need to find some clues as to whether the company can continue paying steadily increasing dividends in the future.

Interest Coverage Ratio

The interest coverage ratio illustrates the size of the company's pre-tax profits relative to the company's interest payments. Generally speaking, the more debt a company has, the more interest it has to pay, and the less that the company has left over to pay out dividends. The interest coverage ratio is calculated by dividing the company's earnings before interest and taxes (EBIT) by the company's interest payments made over the same period of time. Low interest coverage ratios (usually below 2) generally show that the company is having a hard time just trying to make its interest payments. That may signal dividend cuts or eliminations in the future. For this reason, we like to see high interest coverage ratios.

Table 5 shows the interest coverage ratios of McDonald's and Yum Brands over the last 12 months.

McDonald's 16.8
Yum Brands 7.29

 

Table 5: Interest Coverage Ratios of McDonald's and Yum Brands

Table 5 shows us that while Yum Brands was able to cover its interest obligations more than 7 times last year, McDonald's takes the cake, with an interest coverage ratio of almost 17. So, while both companies are excellent in this regard, McDonald's steals the show.

Net Debt To Equity Ratio

The amount of debt that a company has can ultimately influence the future direction of the company's dividend. Companies that have more debt typically pay more in interest. It should also be noted that at some point, the company's debt will need to be repaid. While many companies are working around this by refinancing the debt at low interest rates, this option might not be as attractive when interest rates head back up. When the company finally does extinguish its debt, it may have an adverse effect on whether it can continue paying dividends.

The net debt to equity ratio can offer us some clues as to how much of a problem debt will be when it comes to paying out dividends. It is calculated by subtracting the company's cash position from the company's short and long-term debts, and then dividing that by the company's equity position. The lower this ratio, the better it is for not only the company in question, but for us as investors. Ratios under one are typically considered to be good.

McDonald's 0.71
Yum Brands 1.07

 

Table 6: Net Debt To Equity Ratios of McDonald's and Yum Brands

 

Table 6 shows that while both of these two companies look pretty good in this category, McDonald's gets the edge here.

 

Forecasted Earnings Per Share Growth

Dividend growth can be driven by a couple of different factors. One of these factors is the expansion of the company's payout ratio, where the company decides to pay out a higher percentage of its earnings or free cash flow to shareholders as dividends. However, you can only expand the payout ratio so much. Eventually, you must have free cash flow growth in order to pay steadily increasing dividends. And, we all know that free cash flow growth comes from earnings growth. To get a good idea as to the prospects of a company's future dividend payments, it may behoove us to look at analyst projections for future earnings per share growth over the next couple of years. Table 7 shows the forecasted earnings per share growth rates for McDonald's and Yum Brands over the next couple of years. These numbers come from the analysts at S&P Capital IQ.

Company 2014 2015
McDonald's 6% 8%
Yum Brands 22% 15%

 

Table 7: Forecasted Earnings Per Share Growth for McDonald's and Yum Brands

Both McDonald's and Yum Brands are expected to post solid earnings per share growth over the next couple of years. However, Yum Brands is expected to grow earnings at a much faster rate. This bodes very well for Yum Brands investors, as they can continue to expect solid dividend increases in the future. Meanwhile, shareholders of McDonald's should probably expect to see mid single-digit dividend increases, similar to the one last year.

Conclusion

Today, we have looked at a number of different factors in order to determine the strength and sustainability of the dividends of McDonald's and Yum Brands. These factors include the dividend yield, historical dividend growth rates, payout ratios, interest coverage ratios, net debt to equity ratios, and analyst projections for future earnings per share growth. After giving careful consideration to all of these factors, we can conclude that none of the dividends being paid by either of these companies appear to be in any danger as of this writing.

While McDonald's has a higher dividend yield and a better balance sheet, Yum Brands has shown superior dividend growth over the last 5 years, and lower payout ratios that indicate that there is plenty of room remaining for more dividend increases. Yum Brands is also expected to post much stronger earnings per share growth over the next few years. For these reasons, investors in Yum Brands should continue to see robust dividend growth going forward.

While the dividend of McDonald's is well-covered, a 10% average annual dividend growth rate will be hard to maintain with a 70% free cash flow payout ratio and expected earnings per share growth of only 6-8%. I would expect the dividend growth of McDonald's to be more on par with the 5% increase that we saw last year.

When it comes down to whose dividends are better, I'm going with McDonald's. In spite of the fact that Yum Brands has lower payout ratios and a higher dividend growth rate, the starting yield is so low that if you extended the one-year dividend growth rate of each company indefinitely, it would take at least 12 years for the yield on cost of an investment in Yum Brands to surpass that of an investment in McDonald's. And, the odds of Yum Brands increasing its dividend by an average of 14% or more over the next 12 years are very slim. Then, you have to consider the cumulative dividends that each investment would produce. It would take well over 12 years for the cumulative dividends of an investment in Yum Brands to surpass those of an investment in McDonald's.

Of course, before making a final decision between the two, you must consider other items like valuation, product and geographic diversification, and business models.

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WallStreetBeerMoney.com

"Do Your Own Due Diligence, But By God, Don't Drink Away Your Equity!"

dave@wallstreetbeermoney.com