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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.

McDonald's’ Valuation

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:

V0

E0

$5.16

V1

E0 (1+g)/(1+r)

$5.05

V2

E0((1+g)/(1+r))2

$4.94

V3

E0((1+g)/(1+r))3

$4.83

V4

E0((1+g)/(1+r))4

$4.73

V5

E0((1+g)/(1+r))5

$4.63

D

E0(1+g)5/[r(1+r)5]

$53.79

BV

Equals

$13.92

Fair Value

Equals

$83.12

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:


Summary

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.

Source: McDonald's: Slightly Over-Priced, But a Must Have for the Ultimate Retirement Portfolio