Scope Of Article
The purpose of this article is to calculate the returns one can reasonably expect by buying McDonald's (MCD) at the current price level of $98.70. Our estimates suggest an annualized return of 8.8% based on slight multiple contraction. We are not buyers of McDonald's at this level.
In Chart 1 below, we can see how MCD has consistently grown its earnings and cash flows over the last 11 years. The earnings manifest themselves as an ever increasing level of operating cash flow generation.
In Chart 2 below, it is evident that MCD has been reinvesting its cash flows. We can see a growing capital base of the company. This has been a significant driver of historical growth in Net Income and based on our calculations, we do not see a reversal in this trend.
Chart 3 below shows the trailing 12-month Return On Invested Capital for MCD. Even though it has been a bit weak recently, the trend is still upward sloping. We need to dig a little deeper to understand what is happening.
ROIC Return On Invested Capital is driven by NOPAT (Net Operating Profit After Tax) Margin and Revenue/Invested Capital. In Chart 4 below, we can see that MCD has been pretty consistently increasing revenues flowing out of its invested capital. This suggests that the company is either increasing pricing or selling increasing numbers of hamburgers per store or some combination of the two. Either way the trend is comforting.
MCD has been able to keep its ROIC in an upward trajectory by also improving its profit margins as illustrated in Chart 5 below.
The pie chart below shows how MCD deploys the operating cash it generates.
Valuation / Calculation Of Expected Returns
Earnings Per Share Estimate
There are four building blocks to our earnings per share estimate: Increase in NOPAT from Invested Capital, Organic Growth, Earnings Per Share Uplift from Share Buybacks and Earnings Per Share Dilution from stock compensation.
1. Increase in NOPAT from Invested Capital
Firstly, we took a look at McDonald's cash flows to see how much cash they are generating and how they have historically deployed that cash (see table). We use our own proprietary Adjusted Operating Cashflow number that includes proceeds from employee stock options.
The table below shows exactly how operating cashflow has been deployed over the last 5 and 10 years. Please note that McDonald's current level of buybacks is impacting their capital structure. Going forward we estimate that the company can only reasonably utilize 29.2% of cashflows for buybacks as opposed to an average of 48% over the last 5 years.
Increase in NOPAT from Invested Capital represents the increase in earnings we expect to see from Invested Capital. As can be seen below, MCD reinvests 19.4% of its cash flows in growth capex and acquisitions. We estimate that this will result in a 3.2% increase in net income.
2. Organic Earnings Per Share
An analysis of the trends in the amount of revenue MCD derives from its invested capital and its NOPAT margins give us an annualized organic growth rate of 2.5% over the next five years. Please note this is not saying revenues will grow by 2.4% per year and margins will increase by 0.1 percentage points, but that the ratio of revenues/invested capital will rise by this amount and the NOPAT margin will increase from 21.1% to 21.2% (an increase of 0.1%).
3. Earnings Per Share Uplift from Buybacks
In the table below, we have estimated how much we anticipate Earnings Per Share to grow based on the % of Adjusted Operating Cashflow used for Share Buybacks. Based on the current market capitalization, we estimate the company can sustain buying back 2.0% of its stock every year.
4. Dilution from stock compensation
In the table below, we have estimated the dilutive effect on earnings of the company's stock compensation plans. Over the last 5 years, the average annualized dilution to the basic share count was 0.4%
The table below pulls together the four drivers of our Earnings Per Share estimate. We calculate 7.5% expected Earnings Per Share growth over the next five years.
Our next step is to identify the assumptions we will use to calculate the Internal Rate Of Return for the stock. The table below shows the trailing 12 month P/E ratio of the company of 18.38. In addition, we identified that over the last 5 years, on average the company's P/E has traded at 1.11x the S&P 500's P/E, which would imply a P/E of 16.90. The current trailing 12-month P/E of the S&P 500 is 15.27.
In the table below we calculate the 5-year Internal Rate of Return of holding McDonald's stock based on three scenarios. Scenario 1 assumes that in five years, the stock still trades on its current P/E ratio of 18.38. Scenario 2 assumes that in five years, the stock trades based on its average relative P/E to the S&P 500 of 1.11, which would be 16.90x. Scenario 3 assumes that in five years, the stock trades on a market multiple currently 15.27x (for the S&P 500).
In conclusion, we believe that for patient investors a gross annual return of 8.8% will be realized. This is based on slight multiple contraction. If McDonald's reverts to a market multiple then the return would be 6.8%. We would wait for a pullback in MCD stock to initiate a long position as we do not believe the risk reward ratio is favorable at these levels.