Has McDonald's Price Hit A Ceiling?

May.12.13 | About: McDonald's Corporation (MCD)

McDonald's (NYSE:MCD) stock price has hovered around $100 per share in the past couple months, leaving investors wondering if the stock price has finally exceeded its fair value range (a range between which we think the stock is fairly valued). To answer this question, we perform a rigorous discounted cash-flow methodology and assign an appropriate margin of safety to our point fair value estimate (key components of our Valuentum Buying Index). If McDonald's stock price falls outside this range, only then do we consider the stock to be undervalued or overvalued. Let's see if McDonald's is still reasonably valued despite stalling at the $100 range.

Our Report on McDonald's

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Investment Considerations

Investment Highlights

• McDonald's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.

• McDonald's has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 18.5% in coming years. Total debt-to-EBITDA was 1.4 last year, while debt-to-book capitalization stood at 47.1%.

• The firm's share price performance has been roughly in line with that of the market during the past quarter. We'd expect the firm's stock price to converge to our fair value estimate within the next three years, if our forecasts prove accurate.

• The firm sports a very nice dividend yield of 3.1%. We expect the firm to pay out about 53% of next year's earnings to shareholders as dividends.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. McDonald's 3-year historical return on invested capital (without goodwill) is 25.5%, which is above the estimate of its cost of capital of 10%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. McDonald's free cash flow margin has averaged about 16% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At McDonald's, cash flow from operations increased about 10% from levels registered two years ago, while capital expenditures expanded about 43% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that McDonald's shares are worth between $70.00 and $106.00 each, so the $100 range does look like the upper boundary of its fair value (which may explain why the price has stalled a bit). The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $88 per share represents a price-to earnings (P/E) ratio of about 16.4 times last year's earnings and an implied EV/EBITDA multiple of about 10.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 6.6%. Our model reflects a 5-year projected average operating margin of 32.6%, which is above McDonald's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3% for the next 15 years and 3% in perpetuity. For McDonald's, we use a 10% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $88 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for McDonald's. We think the firm is attractive below $70 per share (the green line), but quite expensive above $106 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate McDonald's fair value at this point in time to be about $88 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of McDonald's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $110 per share in Year 3 represents our existing fair value per share of $88 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from
the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.