McDonald's Investors Pay A Massive Premium For Dividend Stream

Nov.27.13 | About: McDonald's Corporation (MCD)

McDonald's (NYSE:MCD) is one of the world's most known fast food chains. Similarly, McDonald's is known for constant dividend payments and share repurchases in the investor community. The company has a long track record in paying dividends and income investors naturally feel attracted to the stock which is why McDonald's is a cornerstone holding for many shareholders.

Buyer interest has driven shares of McDonald's up to $103.59 on April 12, 2013. Since then shares have fallen back below the $100 mark. Shares are now trading at $98.20 and are up 14% over a one-year period. With falling prices investors ask themselves whether a new investment or additions to an existing position make sense.

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Over a two-year measurement period, McDonald's hasn't performed all that well. When pitched against a variety of other fast food restaurant chains, McDonald's has been the worst performer with a negligible two-year plus of 5%. Tim Hortons (THI) gained 19%, Burger King Worldwide (BKW) 40%, Yum! Brands (NYSE:YUM) 42% and Domino's Pizza (NYSE:DPZ) 122%.

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Dividend discount model

McDonald's has a dividend- and stock split history that goes way back into the 1970s. Companies with long track records of continuous dividend payments and increases make shares highly attractive; at the right price that is. Just the existence of a long remuneration record does not justify a purchase itself.

McDonald's paid $2.87 in dividends in 2012 and is about to pay $3.12 in 2013 (a y-o-y increase of 8.7%). I estimate that McDonald's will pay $3.33 in dividends in 2014 and I assume that the long-term dividend growth rate will trickle down to 5%. Those are generally optimistic assumptions. With capital costs of 10%, McDonald's' intrinsic value stands at about $71 dollar per share. At a current share price of $98.20 the shares have 28% downside potential. Based on a free cash flow to equity model McDonald's has about 12-36% correction potential.

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Market valuation

McDonald's trades at 16.49 times earnings. I generally categorize investments into P/E classes where a P/E range of 13-15 indicates a fair valuation. With a forward earnings multiple of 16.49 McDonald's seems to be overvalued and this notion is confirmed by the dividend discount model from above and by the free cash flow valuations in the related article. The entire restaurant sector, even without consideration of Chipotle Mexican Grill (NYSE:CMG) whose valuation metrics are heavily skewed, appears to be trading at very rich valuations already. The average P/E ratio stands at nearly 21%. Yum! Brands, for instance, trades at almost 22x forward earnings and the company is hopelessly overvalued and definitely not for bargain hunters.

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In terms of dividend performance, McDonald's does have the most attractive dividend yield in the fast food restaurant sector. With a yield of 3.30% its dividend yield is about 76% above the average yield in the peer group. However, given the implications of the dividend discount model, investors pay a heavy premium in order to access McDonald's dividend stream. At these prices income investors can find much better deals in the market. The REIT-, MLP- or basic materials sector for instance offer quite a few investment opportunities which lend themselves to portfolio income strategies (e.g. here and here).

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A summary of the most relevant valuation metrics for the fast food restaurant peer group is provided below.

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Summary

The restaurant sector is trading at very rich multiples and investors pay a substantial growth premium in order to access a mediocre dividend yield. Money is being made when shares are purchased not when they are sold. High purchase prices (low dividend yields) limit future multiple expansions and a heavy concentration on a saturated U.S. fast food market (like in the case of McDonald's) will do little to justify valuation growth.

Investors who seek exposure to either capital gains or income should look at other sectors of the stock market. Tobacco as well as oil- and gas companies offer much better risk/reward ratios for investors who desire regular income but also want to preserve their chances to profit from capital gains. Given the current valuation level of McDonald's and the implied downside risk of 28% by the dividend discount model, I would advise against a purchase in either McDonald's or its restaurant peers.

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.