Big Mac Index

The Big Mac Index is a fun, greasy, and surprisingly useful guide to currency valuation, published by the magazine The Economist since 1986. It's designed as a lighthearted way to test the theory of Purchasing Power Parity (PPP). The big idea behind PPP is that, in the long run, exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services in any two countries. In this case, that “basket” is a single, globally recognized product: the McDonald's Big Mac. By comparing the price of a Big Mac in different countries, the index gives us a tasty yardstick to see if a currency is “overvalued” (too expensive) or “undervalued” (too cheap) relative to the US dollar. It’s a quick bite of economic theory served up in a way everyone can understand.

The logic is simple: the burger should cost the same in New York as it does in Paris, once you've converted the currency. If it doesn't, the exchange rate might be out of whack. Let's cook up an example. Imagine the following scenario:

• The price of a Big Mac in the United States is $5.00.
• The price of a Big Mac in the Eurozone is €4.50.
• The actual exchange rate on the market is $1.10 per €1.00.

Now, let's follow the recipe:

1. Step 1: Calculate the Implied Exchange Rate. This is the exchange rate that would make the burgers cost the same. We find it by dividing the local price by the US price.
   • €4.50 / $5.00 = 0.90
   • This means the PPP-implied exchange rate is $0.90 per €1.00.
2. Step 2: Compare the Implied Rate to the Actual Rate.
   • Implied Rate: $0.90 per €1.00
   • Actual Rate: $1.10 per €1.00
3. Step 3: Determine Over/Under Valuation. Since the actual exchange rate ($1.10) is higher than the implied rate ($0.90), it takes more dollars to buy a euro than the Big Mac price suggests it should. This means the euro is overvalued against the dollar. To find by how much, we use this formula:
   • ((Actual Exchange Rate - Implied Exchange Rate) / Implied Exchange Rate) x 100
   • (($1.10 - $0.90) / $0.90) x 100 = 22.2%
   • Conclusion: Based on Big Mac prices, the euro is about 22% overvalued.

For a value investor, the Big Mac Index isn't just a quirky economic indicator; it's a simple, first-glance tool for understanding the global landscape. While you'd never base an investment solely on a burger, currency valuation is a critical, and often overlooked, piece of the puzzle when analyzing international companies. A significantly overvalued or undervalued currency can have real-world impacts on a business's bottom line:

• Sales: A strong (overvalued) home currency makes a company's exports more expensive for foreign buyers, potentially hurting sales.
• Costs: A weak (undervalued) home currency makes imported raw materials and components more expensive, squeezing profit margins.
• Asset Value: When a multinational company converts its foreign profits back to its home currency, a less favorable exchange rate can shrink those reported earnings.

The Big Mac Index provides a quick mental check, a starting point for thinking about Currency Risk. If you're analyzing a European company and the index suggests the euro is heavily overvalued, it might prompt you to dig deeper into how much of the company's business is exposed to foreign exchange fluctuations.

As fun as it is, the Big Mac Index has some serious flaws that prevent it from being a precise valuation tool. Always take its findings with a grain of salt.

• Local Costs: A large portion of a Big Mac's cost is not traded internationally. Things like local labor, rent, advertising, and taxes vary dramatically from country to country and have a huge impact on the final price. PPP theory works best for goods that can be easily shipped across borders with minimal extra cost.
• Market Position: In the US, McDonald's is a classic fast-food staple. In some other countries, it might be perceived as a more premium, middle-class dining option, allowing it to command a higher price relative to local incomes.
• Competition: The price of a Big Mac can be influenced by the intensity of local competition from other fast-food chains.
• Ingredient Differences: The Big Mac isn't truly identical everywhere. For example, in India, where eating beef is uncommon, McDonald's sells the “Maharaja Mac,” made with chicken or a veggie patty.

Even The Economist acknowledges these shortcomings and now publishes an adjusted version of the index that accounts for a country's GDP per person, which often provides a more nuanced picture.