McDonald’s (NYSE:MCD) is the largest fastest food chain in the world, operating in more than 117 countries. The company has one of the strongest brand images in the world. It is growing at a rapid pace in developing countries, particularly China and the ex-Soviet Union States.
McDonald’s is an immensely profitable company with an operating margin of 31%, which is significantly higher than the industry average of 18%. Net profit margin of 20.6% is almost twice the industry average. Thanks to its increasing profitability, as of July 22, McDonald's year-to-date return was 17%. The company has a low-Beta value of 0.5 with a 14 day average true range of 1.1. As of July 22, McDonald’s was trading at $88.5 with a market cap of $91.89 billion. The company sports a ttm [trailing twelve month] P/E ratio of 18.72 and a forward P/E ratio of 15.84.
McDonald’s has a 3-star rating from Morningstar. Wall Street has diverse opinions on McDonald's future. The bottom line is 6.1% growth, whereas the top-line growth estimate is 13.3%. Average five year annualized growth forecast estimate is 8.6%.
What is the fair value of McDonald’s given the forecast estimates? In this article, the seventh in the series, I will show a step-by-step calculation of McDonald's’ fair value using discounted earnings plus equity model.
Discounted Earnings plus Equity Model
This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value
V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.
Since we are in the middle of the year, it will be more feasible to take the average of ttm EPS of $4.73 along with the mean estimate of $5.59 for the next year.
E0 = EPS = ($4.73 + $5.59) / 2 = $5.16
Wall Street holds diversified opinions on McDonald's’ future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 8.6%. Book value per share is $13.92.
The rest is as follows:
I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. According to my 5 year discounted-earnings-plus-book-value model, the fair-value estimate for McDonald’s is $83.12 per share. As of July 22, McDonald’s was trading at a price of $88.56. I like McDonald’s, and I think the company is a must hold for the long-term. However, the current price seems slightly expensive. Based on my FED+ fair value estimate McDonald’s is overvalued by $5.
O – Metrix Confirmation
If the math above looks too complicated for you, try estimating the fair value using the O-Metrix as such:
O-Metrix = [(Dividend Yield + Growth Estimate) / (P/E Ratio)] * 5
Dividend Yield: Higher is better.
EPS Growth: Higher is better.
P/E Ratio: Lower is better.
The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as five years. I am also continuously checking on specific sectors, and the formula works very well so far.
What is the O-Metrix Score?
- McDonald’s offers a dividend yield of 2.76%. That is a bonus for shareholders.
- Growth estimate is the same as the discounted earnings model and is equal to 8.6%.
- Since we are at the middle of the year, taking the average of ttm [18.72] and forward [15.84] P/E ratios will smooth the results. Thus, the average P/E ratio to be used in the model is 17.28.
O-Metrix = [(2.76 + 8.6) / (17.28] * 5 = 3.29
Depending on the benchmark chosen, the market has an O-Metrix score range between 4 and 5. McDonald's O-Metrix score of 3.29 is below the fair-value range.Back-testing of this ranking system shows that companies with higher-than-average O-Metrix scores beat the market with lower volatility. While the dividend yield is nifty, McDonald’s is slightly over-priced. At a price of $88.56, the company is trading within the D-Grade, below-average-return zone.
Click to enlarge:
McDonald’s stock has always been priced at a premium due to its high growth potential. The average P/E ratio in the last 5 years was 19.6. Annualized EPS growth in the last 5 years was 17.75%. McDonald’s performed really well in the last 5 years, returning a whopping 23% annually.
As of July 22, McDonald’s was trading at $88.56, approximately 6% higher than my fair value estimate of $83. McDonald’s has a great moat in the business. Nevertheless, after returning 17% since January, the stock does not seem to have any catalyst for further gains. Analysts also agree with me. The average target price is $88, implying there is no medium-term potential left in the stock. McDonald’s is a must-have dividend stock for the ultimate retirement portfolio. However, it should be purchased after a pull-back below its fair value.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.