Over the past year, McDonald's (MCD) share price has risen nearly 11% in a move that has added around $10 billion of value to shareholders. While this move is exemplary, it is important to note that price has declined from its recent high and shares are currently down 4% from the middle of April. In this article, I will examine the fundamental drivers, which precipitated the rise in MCD's share price and provide a bearish synopsis for the security.
A History of Returns
In order to objectively analyze McDonald's, I have relied heavily on return on assets. Return on assets is a useful calculation in that it allows investors the ability to examine the profits of a firm in relation to the assets used to generate the profits. The ratio allows for excellent comparison across operating cycles and comprehensively shows how a firm is performing in a given period. Return on assets is calculated by taking the net income across an operating cycle and dividing by average total assets. When examining McDonald's balance sheet, something very noteworthy can be seen: around 70% of its assets is composed of its property and equipment. What this means is that when we study return on assets for McDonald's, we are essentially examining how much profit the firm is able to generate from its tangible restaurants. The table below shows a history of return on assets for McDonald's for the past 5 years.
In the chart above, three distinct economic periods can be seen. In the points below, I have explored these three time periods and concluded with a summarizing table. It is important to understand the fundamental history of McDonald's before we can arrive at any sort of comprehensive investing recommendation.
- The first period for our analysis is from the second quarter of 2008 until the second quarter of 2009. During this period of time, McDonald's experienced conflicting fundamental events. On one side, the financial crisis and Great Recession drove GDP and discretionary spending to low levels impacting the entire business environment. On the other hand, McDonald's provides affordable options to the average American, which means that as the consumer falls upon hard times, McDonald's is a viable option to more expensive competitors. These conflicting variables were such that McDonald's experienced a slight languish in firm performance and its share price fell nearly 8%.
- The next period of analysis is from the third quarter of 2009 until the first quarter of 2012. During this period, McDonald's entered an excellent period of growth. This rise in growth was precipitated by a strengthening economy and aggressive competition by MCD. What is most relevant to our analysis however is that as McDonald's improved itself fundamentally, investors flocked to its shares. During these few quarters, share price rose an astounding 94%.
- The final period for our analysis is from the second quarter of 2012, until the second quarter of 2013. This period of analysis marks the catalyst for our bearish recommendation. Over the past year, McDonald's has experienced a decrease in firm performance. Return on assets is currently in free-fall and profit margins are in decline. Despite the fact that returns are falling and profit margin is nearing a four-year low, shares have continued to rise around 8%
The table below summarizes the discussion above.
In the table above, a clear economic relationship can be seen. As a firm demonstrates growth through expanding return on assets, its shares tend to rise. Conversely, as a firm experiences a decline in economic performance, its shares tend to fall. Not only is this relationship simple and intuitive, but it has also proven to be historically profitable. Investors who had used changes on return on assets as the basis for their decision making could have nearly doubled their stake over the past five years.
What is most noteworthy in the table above is the most recent economic period. McDonald's is currently in fundamental decline. Organizational returns are falling and profit margins are nearing four-year lows. Despite this degradation of performance, shares have risen around 8%. In my opinion, this decoupling between firm performance and share price represents an investment opportunity. I believe that the market is waking up to this fundamental relationship in that even though shares are up 8% year-over-year, they are currently down 4% over the past two months. It is my belief that the tactical investor should give serious thought to positioning himself to profit from a decline in McDonald's shares.