Another year completed and another annual report to go through. Back in late January, McDonald's Corporation (NYSE:MCD) announced 4Q 2013 and full year earnings so what better time than the present to input the new data and update my valuation analysis. McDonald's Corporation closed trading at $96.18 on Monday, March 24th giving a current yield of 3.37%.
Analysts followed by Yahoo! Finance expect McDonald's Corp. to grow earnings 7.78% per year over the next five years and I've assumed they can grow at 5.84% (75% of 7.78%) for the next 3 years and at 4.50% per year thereafter. Running these numbers through a three-stage DCF analysis with a 10% discount rate and summing over 30 years yields a fair value price of $106.50. This means the shares are trading at a 9.7% discount to the discounted cash flow analysis.
The Graham Number valuation method was conceived of by Benjamin Graham, the father of value investing, and calculates the maximum price one should pay for a company given the earnings and book value. McDonald's earned $5.55 per share in fiscal year 2013 and ended with a book value per share of $16.17. The Graham Number is calculated to be $44.94, suggesting that it is overvalued by 114.0%. If we assume that book value will remain constant over the next year and use the analyst estimate of $5.82 for this year's earnings, the new Graham Number is $46.02. Shares are still trading at a 109.0% premium to the forward Graham Number.
Average High Dividend Yield:
McDonald's average high dividend yield for the past 5 years is 3.59% and for the past 10 years is 3.22%. This gives target prices of $90.31 and $100.21, respectively, based on the current annual dividend of $3.24. With growth slowing and McDonald's becoming a "stodgier" stock I expect the yield, the average high yield, to be closer to the 5-year average going forward. McDonald's is currently trading at a 6.5% premium to the 5-year high dividend yield model.
Average Low P/E Ratio:
McDonald's average low P/E ratio for the past 5 years is 14.38 and for the past 10 years is 14.66. This corresponds to a price per share of $83.71 and $85.30, respectively, based off the analyst estimate of $5.82 per share for fiscal year 2014. Since the low P/E ratios are essentially the same, I'll use the average of the two low P/E ratio models, $84.51, in my target entry price calculation. McDonald's Corp. is currently trading at 13.8% premium to this price.
Average Low P/S Ratio:
McDonald's average low P/S ratio for the past 5 years is 2.84 and for the past 10 years is 2.41. This corresponds to a price per share of $82.19 and $69.62, respectively, based off the analyst estimate for revenue growth from FY 2013 to FY 2014. 2014 revenue per share is estimated at $28.92 based off the analyst estimate for growth of 3.50% and not potential share buybacks. Currently, McDonald's P/S ratio is 3.36 on a trailing twelve months basis. Once again I'll use the average of the two P/S ratio models, $75.90, in my target entry price calculation. McDonald's Corp. is trading at a 26.7% premium to this price.
Gordon Growth Model:
The Gordon Growth Model is a quick way to calculate the fair value of a company using the current dividend, the expected dividend growth rate, and your required rate of return or discount rate. Assuming a constant 6.00% dividend growth rate and a discount rate of 9.00%, the GGM valuation method yields a fair price of $108.00. McDonald's Corp. is trading at a 10.9% discount to this price.
Dividend Discount Model:
For the DDM, I assumed that McDonald's will be able to grow dividends for the next 5 years at the lowest of the 1-, 3-, 4- or 5-year growth rates or 15%. In this case that would be 8.71%. After that I assumed it can continue to raise dividends for 3 years at 75% of 8.71%, or 6.53%, and in perpetuity at 5.5%. The dividend growth rates are based off fiscal year payouts and don't necessarily correspond to quarter over quarter increases. To calculate the value I used a discount rate of 9%. Based on the DDM, McDonald's Corp. is worth $95.61, meaning it's fairly valued.
McDonald's trailing P/E is 17.33 and it's forward P/E is 15.22. The PE3 based on the average earnings for the last 3 years is 17.83. I like to see the PE3 be less than 15 which it is currently over. Compared to its industry peers McDonald's is undervalued against Burger King Worldwide (BKW) 40.20 and Yum! Brands Inc. (NYSE:YUM) 31.58. Comparisons are on a TTM basis. McDonald's is trading at a PEG ratio of 2.13 which has shares overvalued versus both BKW (1.78) and YUM (1.68). None of the companies are trading at a discount based on the PEG ratio where 1 is generally considered fair value.
McDonald's gross margins for FY 2012 and FY 2013 were 39.2% and 38.8%, respectively, and they have averaged a 41.0% gross profit margin over the last 10 years. The net income margin for the same years were 19.8% and 19.9% with a ten-year average of 17.1%. I typically like to see gross margins greater than 60% and at least higher than 40% with net income margins being 10% and at least 7%. McDonald's is hovering around the 40% gross margin level but has consistently been well above the 10% net income margin threshold. I feel it's prudent to make a company to company comparison as well, as each industry allows for different margins. Over the TTM, Burger King Worldwide's gross margin was 70% and Yum! Brands Inc's gross margin was 26%. For net income margin, Burger King Worldwide was at 20.4% while Yum! Brands Inc. was at 8.3%. McDonald's Corp. is between both competitors on both gross margin and net profit margin. I was surprised to see the big difference in both gross and net income margins between the three companies.
Since the end of FY 2003 McDonald's has been awesome at buying back shares. From 2003 to the end of 2013, the share count has decreased from 1.277B to 1.006B. That's a total of 21.2% of the shares outstanding since the start and is good for an average annual decrease of 2.4%. This is a pretty amazing feat for just about any company and a trend I'd like to see continue.
A negative number for the % change value means shares were bought back by the company and a positive value means the shares outstanding increased.
McDonald's is a dividend champion with 38 consecutive years of increasing the dividend. The dividend has been increased at a 8.71%, 11.35%, 13.87%, and 22.80% rate over the last 1-, 3-, 5-, and 10-year periods, respectively. Dividend increases are based off fiscal year payouts and don't necessarily correspond to annual payouts. Historically McDonald's has delivered some amazing dividend growth but the most recent increase was fairly meager at just 5.19%. I'd expect the dividend increase to more closely mirror the growth of earnings as the payout ratio has increased to over 50% for the last two fiscal years. The payout ratio based off earnings per share has averaged 50.9% over the last 5 fiscal years with a low of 48.0% and a high of 53.6%. The dividend is still well covered by earnings but there's not much room for rapid dividend growth above the growth of earnings.
McDonald's operating cash flow has increased from $5.917B in FY 2008 to $7.121B in FY 2013 with an average annual increase of 3.77%. Capital expenditures have increased along the way from $2.136B in FY 2008 to $2.825B in FY 2013, or 5.75% per year. With capex increasing faster than operating cash flow, McDonald's free cash flow has grown relatively slowly. Free cash flow has increased from $3.782B in FY 2008 to $4.296B in FY 2013. That's an average annual increase of just 2.58%. I like to calculate the free cash flow after paying the dividend as well since dividends are fairly sticky once put in place. Starting in FY 2008 the FCFaD has decreased from $1.958B to $1.181B in FY 2013. That's an average annual decline of 9.6%. Dividends are paid from cash so it's important to check the payout ratio based off free cash flow. Over the last 5 years the FCF payout ratio has averaged 64.3%, but it's been over 70% the last 2 fiscal years. Signs continue to point towards lower dividend growth barring drastic improvements in cash flow.
Return on Equity and Return on Capital Invested:
McDonald's ROE has averaged a very strong 35.0% since FY 2009 while the ROCI has averaged 19.1%. Its ROE and ROCI have been very consistent as well from FY 2009 until FY 2013 with very little variation. This shows that management is able to consistently earn a high return both on shareholder equity and invested capital. While I'd love to see increasing levels of ROE and ROCI, if it can be maintained at current levels then I'd be happy just as well. Long-term debt has increased by almost 34% since FY 2009 which has led to the long-term debt to equity ratio increasing from .75 to 0.88. The long-term debt-to-capitalization ratio has increased as well from 42.9% to 46.9% over the last five fiscal years. I'd like to see the debt levels stay around current levels or decline as it looks like management isn't able to fully fund growth, dividends, and buybacks with current operations.
Revenue and Net Income:
Since the basis of dividend growth is revenue and net income growth, we'll now look at how McDonald's Corp. has done on that front. Their revenue growth since the end of FY 2008 has been okay at a 3.62% average annual increase. Although it's not surprising considering it's hard to grow revenue of almost $23B by large margins. Net income has been better with a 5.3% annual rate from FY 2009 through FY 2013. Revenue growth is expected be quite strong, given the recent history, with forecasts of 3.50% and 4.70% for the next two years. With continued improvement in operations, net income should continue to grow faster than revenue.
This chart shows the historical high and low prices since 2004 and the forecast based on the low, average, and high P/E ratios and the expected EPS values. I have also included a forecast based off a P/E ratio that is only 75% of the average low P/E ratio. I like to the look to buy at the 75% Low P/E price or lower to provide for a larger margin of safety, although this price doesn't usually come around very often. In the case of McDonald's, the target low P/E is 14.5 and the 0.75 * low P/E is 10.9. This corresponds to an entry price of $84.51 based off the expected earnings for FY 2014 of $5.82, with a 75% target price of $62.78. Currently McDonald's is trading at a $33.40 premium to the 75% low P/E target price and an $11.67 premium to the low P/E price. If you look at the chart you'll notice that the current price line intersects the average forward P/E line at 2014, suggesting that it's currently fairly valued. That's good news for long-term investors and could mean that shares are currently trading at an average valuation as you're not paying up for much future growth at current prices. The current price intersects the low P/E price line around 2016.
The average of all the valuation models gives a target entry price of $86.69 which means that McDonald's Corp. is currently trading at a 10.9% premium to the target entry price. I've also calculated it with the highest and lowest valuation methods thrown out. In this case, the Graham Number and Gordon Growth Model valuations are removed and the new average is $90.57. McDonald's Corp. is trading at a 6.2% premium to this price as well.
Assuming that McDonald's Corp. can grow their earnings and dividends at the rates that I assumed, you're looking at decent returns over the next 5 years at current prices. In 2018, EPS would be $7.85 and slapping an average P/E of 16.47 gives a price of $129.33. Over the next 5 years you'd also receive $20.96 per share in dividends for a total return of 56.26% which is good for a 9.34% annualized rate if you purchase at the current price. If you purchase at the target entry price of $90.57 the 5-year total return would be 65.94% or a 10.66% annualized return.
According to Yahoo! Finance, the 1-year target estimate is $103.06 suggesting that the share price has about 7.2% upside over the next year. Morningstar's fair value estimate is $105.00 suggesting about 9.2% upside and has it rated as a 4 out of 5 star stock meaning it's trading below the fair value estimate.
McDonald's operates over 35,000 restaurants in more than 100 countries globally and serve over 70 million people daily. Approximately 80% of the 35,000 restaurants are franchised, meaning that McDonald's is able to collect a fee for the franchiser to use the McDonald's brand. Over the last 5 years McDonald's has been spending lots of money on revamping their stores to modernize and make them more inviting to customers as tastes have changed.
The biggest concern for McDonald's has been struggling same store sales comps as customers have been switching towards healthier and fast/casual restaurants such as Chipotle Mexican Grill (NYSE:CMG) and Panera Bread (NASDAQ:PNRA). Fast food isn't under nearly the same national scrutiny as the soda makers like The Coca-Cola Company (NYSE:KO) but the winds of change will continue to push for healthier menu options. In order to combat declining same store sales, management has been introducing new menu items to entice customers back into their storefronts. The McCafe line of coffees and items such as the Mighty Wings could provide higher growth going forward as the traditional burger and fries model comes under closer watch due to the obesity "epidemic" that plagues much of the developed world.
I'm most excited about the prospects of the McCafe coffees and the new pastries that are being offered in the San Diego area. McDonald's Corp. pioneered the expansion into serving breakfast items and I hope to see new, healthier options to entice customers to part ways with their money. With the menu testing, McDonald's is selling pastries for $1.99 if you buy them separately but for $1.29 if you purchase with one of their McCafe coffees. Personally I don't drink coffee so I can't speak to the difference between a cup of Starbucks (NASDAQ:SBUX) and a McCafe, but my guess is that for the ones that are loaded with other flavors that there isn't a lot of difference. I hope, and expect, the expansion of the breakfast menu to provide for growth in the developed markets.
McDonald's will also continue to grow internationally with the more traditional method of expanding store count. China represents a huge opportunity for McDonald's, as well as just about any other company on the planet, with their massive 1.36 billion population. As of 2012, McDonald's had 14,146 restaurants in the United States with a person per store ratio of 22,461. As of 2013, McDonald's had just 1,800 restaurants in China with a person per store ratio of 757,488. If McDonald's can reach even double the person per store ratio (44,922) that they have in the United States that would mean an additional 28,500 stores could be opened in China alone, or an increase of 80% from the current global store count. Obviously getting the expansion right is of high importance for McDonald's and its shareholders as there's a huge market available.
Overall I feel that McDonald's Corp. represents fairly good value in the dividend growth space and an otherwise heated market. Shares are currently offering a dividend yield of 3.37%. Revenue and earnings growth isn't expected to be all that stellar over the next few years, but as expansion into China and new menu items draw customers back to their stores there's plenty of growth catalysts. The dividend history is stellar with 38 consecutive years of increasing the dividend. My biggest concerns are with the cash flow. McDonald's hasn't been able to cover the share buybacks and dividend payments with free cash flow which has led to a deteriorating, although still strong, balance sheet. I expect to see dividend increases more closely match growth in earnings over the next few years as there isn't as much room on the balance sheet to allow for higher dividends without increasing debt levels. Given its operational history I'd be willing to give McDonald's a chance to work things out as the company and dividends continue to grow year in and year out. There's a lot of growth plans in the works which typically leads to tighter margins in the short term. If I didn't already own shares of McDonald's I'd feel comfortable initiating a position here although I'm looking for a bit better value with my current investment capital. McDonald's relative valuation to the market as a whole and higher dividend yield could make for a compelling investment right now. with group is a bit overvalued at current levels.
What do you think about McDonald's Corp. as a DG investment? How do you think the long-term dividend growth prospects are?
A full list of my holdings can be found here.
Disclosure: I am long MCD. 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.
Additional disclosure: I am not a financial professional and all thoughts/ideas here are my own and for entertainment purposes only. Investing involves risks. Please consult a financial professional and do your own due diligence before investing. The author is not responsible for losses of any kind by readers. All charts/images and data are sourced from my personal stock analysis spreadsheet, Morningstar, Yahoo! Finance, or McDonald's Corporation Investor Relations page.