Better Buy: Shake Shack Inc. vs. McDonald's

By Rich Duprey Markets Fool.com

One is the epitome of fast food; the other, the embodiment of high-priced fast casual fare. Although they occupy opposite ends of the spectrum, McDonald's (NYSE: MCD) and Shake Shack (NYSE: SHAK) clearly show there isn't a single way to profit from a hamburger or from a hungry consumer's stomach.

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Shake Shack has forced consumers -- and rival McDonald's -- to rethink what a burger stand should be. Image source: Flickr via m01229.

Yet even though both are successful in their respective niches, that doesn't mean they're equal investment opportunities. So let's see how McDonald's and Shake Shack stack up against one another and why one might be a smarter pick for investors.

Valuation

Neither McDonald's nor Shake Shack has been able to outperform the stock market over the past year, though the fast-food joint substantially leads its better burger rival. Where Shake Shack is up just 1% since last January, McDonald's has gained more than 7% over the same time period. That still falls far short of the S&P 500, which has surged nearly 18% in the last 12 months.

When we look at each companies valuations in comparison to the overall market, McDonald's offers something much more reasonable than does Shake Shack. The price-to-earnings ratio of the market index stands just north of 26, though its mean puts its price closer to 15 times the earnings of its components. While McDonald's PE of 22.5 is fairly valued to somewhat overvalued, Shake Shack's multiple of 80 times its last 12 months earnings per share firmly places it in nosebleed territory.

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Even when looking at estimated earnings performance over the next year, the better burger stand's valuation doesn't improve much: It goes for 64 times 2017's earnings, whereas McDonald's comes in at less than 20 times estimates.

Image source: McDonald's.

Certainly the market is putting a substantial premium on Shake Shack because it views it as a growth stock that has years of profitable performance ahead of it, and McDonald's, being the granddaddy of fast food, is seen as more staid. But that seemingly overstates the better burger shop's potential.

Growth potential

Analysts forecast that McDonald's will grow earnings over the next five years at a rate less than 10% annually, but they anticipate Shake Shack will be able to expand its profits by more than 26% annually, which would actually allow it to double earnings in three years' time, but is that feasible?

It has more than 100 restaurants opened around the world and plans to open another 30 this year, but same-restaurant sales -- or same-Shack sales, as Shake Shack calls them -- have fallen precipitously since it went public. Third-quarter comps, in fact, were just 2.9% compared to 17% in the same period in 2015. Moreover, its Shack-level operating profits fell by 160 basis points in the quarter because of higher labor costs after it raised employee minimum wages from $10.50 to $12 per hour at the start of last year. Some cities, like New York, pay even more.

Image source: Flickr via Mike Mozart.

It was forced to raise prices after doing so to pay for the wage hikes -- it was the third time in the preceding 12 months it had to do so -- and Shake Shack just announced it was raising prices yet again to compensate for its above-market pay. There would seemingly be an upper limit people will pay for a burger, even if it is arguably of higher quality.

Fast-casual's decline

While McDonald's has also raised employee wages, as the value leader in burgers, it's been attracting more customers who are looking for good food at a fair price. Its comps were up 3.5% in the third quarter, and its operating income was up 7% when the effects of currency exchange rates were removed. It did so by making some smart moves like introducing all-day breakfast and smart value meal bundles. Shake Shack's efforts seem more derivative, like adding a chicken sandwich to its menu.

Still, fast-casual restaurants are among the hardest-hit in an industry suffering a broad-based slow down, while the quick-serve sector has been one of only two segments to consistently enjoy positive comp sales each quarter since the third quarter of 2015 (upscale dining is the other). Shake Shack's expansion plans may become much more difficult to realize in such an environment.

McDonald's has its own problems in that customer traffic is still negative, and over the past eight years, restaurant comp traffic has declined over 13%. That makes the growth prospects something of a toss-up between the two, but with McDonald's comps moving in the right direction, I see it tilting in the fast-food joint's favor.

Image source: McDonald's.

Shareholder value

In the third quarter, McDonald's said it returned to shareholders some $3.4 billion through stock buybacks and dividends. The burger king pays an annual dividend of $3.76 per share that currently yields 3.1%, which it hiked 6% to begin the fourth quarter. Over the past three years, its cumulative return to shareholders totals $27.8 billion, and it has a target of around $30 billion, so investors can probably expect a few billion dollars more to be returned to them this quarter.

Shake Shack, on the other hand, pays no dividend, which is not surprising for a new, relatively young company. You want them plowing their profits back into the business to keep it growing, but it also hasn't bought back any of its stock. It did have a secondary offering that allowed some early investors to cash out some of their holdings. There may come a time for buybacks and dividends, but that doesn't appear to be now.

The verdict

In the three broad areas we looked at today of valuation, growth opportunities, and shareholder value, McDonald's was the clear choice -- or at least the better bet. For investors looking for a burger chain to put their money into, the Golden Arches could just be the golden opportunity they are looking for.

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Rich Duprey has no position in any stocks mentioned. The Motley Fool is short Shake Shack. The Motley Fool has a disclosure policy.