Shares of McDonald's Corporation (MCD) have recovered by 15.2% from their 52-week low of $83.31 touched in November 2012. At $95.95, the stock is trading near the mid-point of the 52-week price band from $83.31 to $101.29 and offers a decent dividend yield at 3.2%. Should investors ride on the current price uptrend? In this article, I will elaborate on my valuation analysis which may assist you in formulating an appropriate investment decision.
Sell-side analysts on average predict the firm's revenue, EBITDA, and EPS to grow at CAGRs of 5.8%, 6.1%, and 9.6%, respectively, over the current and next calendar years (see comparable chart below). Those consensus estimates are notably below the averages of 7.0%, 10.6%, and 19.0%, respectively, for a group consisting of McDonald's primary peers. Similarly, the company's EBITDA margin is forecasted to expand by just 0.2% over the same horizon, compared to the peer average of 1.0% increase. On the profit side, McDonald's has demonstrated a superior profitability performance as all of the company's margin and capital return metrics are considerably above the group averages. The firm carries a fairly in-line debt level as reflected by its above-average debt to capitalization ratio, but below-average debt to EBITDA multiple. In terms of liquidity, McDonald's has been able to maintain a robust free cash flow margin which is markedly above the par. Both the firm's current and quick ratios are almost comparable to the peer averages, reflecting a healthy corporate balance sheet.
To summarize the financial comparisons, McDonald's relatively lower growth potential due to its large restaurant base would likely be the primary drag on the stock valuation. However, given the company's significant global presence, large operation scale, as well as its superior profitability and cash flow generation, I believe the stock's fair value should trade in line with the peer-average level or even command a slight valuation premium. Nevertheless, the current stock valuations at 10.2x forward EBITDA (next 12 months) and 16.5x forward EPS (next 12 months) together represent an average discount of 5.8% to the peer-average trading multiples, suggesting McDonald's shares are modestly undervalued on a relative basis.
From a historical standpoint, McDonald's trailing EV/EBITDA multiple of 10.8x is now trading at a slight premium of 5.2% over its 5-year historical average at 10.2x (see chart below). This comparison implies an attractive valuation level as I believe an even higher premium can be substantiated by the fact that 1) McDonald's capital return metrics including ROE and ROIC have been steadily improved over the past 5 years; 2) The company has also seen a notable expansion in its various profitability margins over the same period; and 3) Although the revenue, EBITDA, and EPS growth rates have slowed down, the market's consensus growth estimates are showing a trend of recovery and stabilization over the current and next years, and the expected growth rates are not markedly below their 5-year average level (see charts below).
Further, McDonald's forward P/E multiple of 16.5x is trading at 14.6% above the same multiple of the S&P 500 Index, which currently stands at 14.4x (see chart below). In my view, McDonald's deserves a solid valuation premium over the market provided that 1) the company's long-term earnings growth rate of 9.8% is above the average estimate of 8.6% for the S&P 500 companies; 2) McDonald's has a significant market share in almost every markets it operates; and 3) the stock offers a sustainable 3.2% dividend yield, which is above the average yield for the S&P 500 Index. It should be noted that the stock's P/E premium over the market is now below the 1-year average of 19.8%, again indicating an attractive valuation level.
To test the stock's margin of safety, I employed a dividend yield analysis. McDonald's has a track record of raising dividend. Since 2010, the company has raised the dividend per share for 3 times by 10.9%, 14.8%, and 10.0%, consecutively. Given the robust and stable free cash flow generation, I believe McDonald's should possess an ample capacity to at least sustain the current pace of the dividend growth. Additionally, under the current low-interest market environment, strong investor demand for quality high-yield assets continues to persist. As such, given that McDonald's dividend yield is already at 3.2%, its upside would likely be weighed by the significant demand from the income-oriented investors. Hence, assuming a target dividend yield range from 3.0% to 4.0% (McDonald's yield has never reached this level), and supposing that the annualized dividend per share would be raised by just 8.0% from the current level of $3.08 to $3.33 in the November 2013 payment period, this conservative scenario would suggest a stock value range from $83.25 to $111.00, or a price return range from -13.2% to 15.7%. By considering the 1-year 3.2% dividend income, the return would range from -10.0% to 18.9%, representing an attractive risk/reward provided that the assumptions employed are very conservative.
In a recent research note, R.J. Hottovy, a research analyst at Morningstar, elaborated on his positive view on the company which I tend to agree on (sourced from Thomson One, Equity Research):
"McDonald's dominates the global quick-service restaurant landscape. Although there are more Subway franchise units in the U.S. and Yum Brands has the largest number of restaurants across the globe, McDonald's maintains a sizable system sales lead. McDonald's generated $86 billion in sales at its company-owned and franchised restaurants during 2011 (roughly 4% of the $1.8 trillion global restaurant industry), doubling Yum Brands' $38 billion and dwarfing Subway's $11 billion. This comes out to almost $2.7 million per McDonald's restaurant, making the locations the most productive among publicly traded quick-service restaurant operators. With an extremely strong brand, a cohesive franchisee system, tremendous scale advantages, and leading share in virtually every country in which it operates, McDonald's has the widest economic moat in the restaurant industry, in our opinion."
In conclusion, despite the recent price appreciation, McDonald's shares remain attractively valued. In the light of the company's solid operation and the stock's tempting risk/reward profile, I recommend acquiring the shares now, especially for long-horizon investors.
The comparable analysis chart is created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data in the article and the charts is sourced from Capital IQ unless otherwise specified.
Disclosure: I am long MCD.