McDonald's Shares A Buy On Dividend Growth And Not Much Else

Sep. 2.14 | About: McDonald's Corporation (MCD)

Summary

Shares of MCD have traded sideways in recent times on stagnant earnings.

Structural issues at home and in Asia have hampered growth and may continue to do so.

MCD's dividend growth make it a great income vehicle and dividend increases will make it that much more attractive.

Shareholders in McDonald's Corp (NYSE:MCD) have experienced some sideways action in their holdings over the past 18 months or so as earnings growth has stagnated at the fast food giant. Still, shares are near highs and most investors that are long MCD have done very well. Given the recent, very rapid decline of about $10 and the dividend growth story that is in play at MCD, are shares a value here? In this article we'll take a look at MCD from a value and dividend growth story perspective.

Click to enlarge

To do this I'll use a DCF-type model you can read more about here. The model uses inputs such as earnings estimates, which I've sourced from Yahoo!, dividends, which I've set at a steady 58% payout ratio of earnings, and a discount rate, which I've set very low at the 10 Year Treasury plus a risk premium of 6%, reflecting the stability and predictability of MCD's business.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$5.55

$5.57

$6.01

$6.38

$6.78

$7.19

x(1+Forecasted earnings growth)

0.40%

7.90%

6.16%

6.16%

6.16%

6.16%

=Forecasted earnings per share

$5.57

$6.01

$6.38

$6.78

$7.19

$7.64

Equity Book Value Forecasts

Equity book value at beginning of year

$16.45

$18.78

$21.31

$23.99

$26.83

$29.86

Earnings per share

$5.57

$6.01

$6.38

$6.78

$7.19

$7.64

-Dividends per share

$3.24

$3.49

$3.70

$3.93

$4.17

$4.43

=Equity book value at EOY

$16.45

$18.78

$21.31

$23.99

$26.83

$29.86

$33.06

Abnormal earnings

Equity book value at begin of year

$16.45

$18.78

$21.31

$23.99

$26.83

$29.86

x Equity cost of capital

8.40%

8.40%

8.40%

8.40%

8.40%

8.40%

8.40%

=Normal earnings

$1.38

$1.58

$1.79

$2.02

$2.25

$2.51

Forecasted EPS

$5.57

$6.01

$6.38

$6.78

$7.19

$7.64

-Normal earnings

$1.38

$1.58

$1.79

$2.02

$2.25

$2.51

=Abnormal earnings

$4.19

$4.43

$4.59

$4.76

$4.94

$5.13

Valuation

Future abnormal earnings

$4.19

$4.43

$4.59

$4.76

$4.94

$5.13

x discount factor(0.084)

0.923

0.851

0.785

0.724

0.668

0.616

=Abnormal earnings disc to present

$3.87

$3.77

$3.61

$3.45

$3.30

$3.16

Abnormal earnings in year +6

$5.13

Assumed long-term growth rate

3.00%

Value of terminal year

$94.97

Estimated share price

Sum of discounted AE over horizon

$17.99

+PV of terminal year AE

$58.54

=PV of all AE

$76.53

+Current equity book value

$16.45

=Estimated current share price

$92.98

Click to enlarge

As we can see the model produces a fair value that is less than $1 away from where shares currently trade as I write this. Thus, the model is implying that MCD is fairly valued right now. But does that mean we should buy? Or avoid it?

To figure this out we need to understand what we're looking at. First, the model produces a fair value and not a price target. A price target is a multiple of EPS projected out into the future; the fair value the model produces is the price at which shares are a good buy today, given the inputs I described above. In other words, the present value of MCD's future earnings stream, adjusted for dividends, is around $93. I prefer this approach to a price target as it gives a more concrete buy or sell recommendation, in my opinion.

Now, let's look at the assumptions in the model in order to determine if they are reasonable. Beginning with earnings growth, we see that the company is expected to grow earnings at around 6% for the foreseeable future, which is in line with recent years' earnings growth. On the surface, I don't have a problem with this growth rate as it is very achievable. However, even though MCD has produced that growth in the past, it doesn't necessarily mean it can in the future.

For one thing, MCD has been struggling recently with growing sales organically. It has been a while since the Golden Arches has wowed investors with its comp sales and July numbers were downright terrible, causing the sharp decline in shares we see in the chart above. However, this isn't new for MCD and investors have looked past it n recent times.

Then there are the quality control issues the company is facing in Asia. This is a huge black eye for the company and although it seems to be a victim of a bad supplier, the fact is that the company was serving expired food to its customers. The company has responded by increasing quality checks but time will tell what the long term damage to its reputation is.

The real reason that investors buy MCD is for the dividend. Earnings do not make MCD a screaming buy at this point because I'm not sure it can hit 6% earnings growth with the structural problems it has. Perhaps it will but I honestly wouldn't be surprised if MCD squeaks by with 2% or 3% earnings growth annually for the next couple of years. The company has some pretty big problems but is overall a very sound business that still makes billions of dollars a year and that means it has the firepower to pay that huge dividend.

I've set the payout at 58% of earnings going forward but MCD has room to expand that. At the current yield of 3.5% I think MCD is a great candidate for a retirement portfolio. The company is still in a dominant position in its industry and produces steady, reliable cash each year with which to pay the dividend. It has also shown a propensity to increase its dividend, making returns to shareholders a priority. This is exactly what you want from a dividend growth position and MCD is the poster child for it. The current yield is great but even better when you consider that it will be higher next year and the year after that and the year after that. MCD won't stop raising its dividend until it runs out of earnings and that isn't going to happen for a very long time, if ever.

In short, I don't think you buy MCD at $93 for its value. Shares aren't really that expensive but they aren't cheap either on an earnings basis. If you consider its valuation in light of meager earnings growth and some serious issues in Asia and at home, I don't think it will be easy for MCD to hit 6% earnings growth. However, if you want a great dividend that is virtually guaranteed to increase every year, MCD's ~3.4% current yield is tough to pass up. I love MCD as a dividend growth story but not much else.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.