On March 18th, 2011, shares of McDonald's (MCD) had a fifty-two week low of $72.89. Since then, McDonald's has climbed up to the $100 level and last traded at $99.47. That's a 36.46% stock price increase in less than a year. Anytime you see that kind of positive stock price movement with a large-cap stock, you have to wonder if you're the guy showing up at 3 AM with a six pack of beer, missing the implicit message that the party may be over. As Shakespeare once said in the Merry Wives of Windsor, "Better three hours too soon than a minute too late!" Warren Buffett warned us that the investors of today do not profit from yesterday's growth, and there are two facts about McDonald's stock that make me wary of considering it as a potential investment.
The first is that the dividend increases are most likely going to decrease from their recent five and ten year growth rates. Over the past five years, McDonald's has grown its dividend by 29.5% annually, and over the past ten years, McDonald's has grown its dividend by 26.0% annually. This is fantastic growth, but the dividend has been growing much faster than the earnings per share growth -- EPS -- has grown 18.0% annually over the past five years and 18.0% and 11.5% over the past ten years. These are both fantastic numbers growth numbers for a large-cap company, but still, the dividend has been growing about twice as fast as earnings over that time frame. Naturally, this has caused the firm's payout ratio to increase over the past decade, and I made a chart of the annual dividends, earnings per share, payout ratios, and average annual P/E's ratios for McDonald's dating back to 2001.
In 2001 and 2002, McDonald's had a low payout ratio below 20%. It was well positioned to raise its dividend by a larger percentage than its earnings growth over the following years, and that is exactly what the company did. From 2001 to 2011, McDonald's went from paying out about a fifth of its earnings as dividends to about half of its earnings as dividends. Unless you believe McDonald's will be growing its earnings per share by around 20% annually over the next decade or if you believe the company will raise its payout ratio to 75-80% over the coming decade (perhaps due to a mixture of near 15-20% dividend growth and 10-15% earnings growth), then it's unlikely that current investors will get to experience the same type of dividend growth that investors during the 2001-2011 period achieved.
McDonald's has generated $5.27 per share over the past twelve months, and currently trades at $99.47. That's a trailing P/E ratio of 18.87, and the last time the company had an average annual P/E ratio that high was in 2001, when earnings were down due to the backlash against unhealthy foods that dominated the headlines at the time. During the past several years, you could buy shares of McDonald's for 15-16x earnings. That would imply a price between $79.05 and $84.32. If you want to pay a higher price than the recent historical average for the stock, there should be a reason why you think the company will be generating greater growth to justify the higher multiple. Is the current medium to long term outlook for McDonald's better now than it was in 2008, 2009, and 2010 when the stock traded at a lower multiple?
From 2007 to 2011, McDonald's grew earnings from $2.91 to $5.25. That's a 180% earnings per share increase. If you bought those shares at the average price in 2007, you would have paid 17.6x earnings. McDonald's is trading at a slightly greater multiple today, and I think it's on the very optimistic side to assume that McDonald's will come close to replicating its splendid history from 2012-2016 that we saw from 2007-2011.
Of course, the good thing about McDonald's is that it does not have to perform as well from 2012-2022 as it did from 2001-2011 to merit a status as a good investment. But there are two things I'm cautious about. The payout ratio went up by about 2.5x over the past decade, and I think that dividends will have to either slightly exceed or fall in line with earnings over the next five to ten years. That's not necessarily a bad thing, as Value Line is predicting that McDonald's will be able to grow earnings by 9% annually over the next five years. But again, 9% earnings and dividend growth is much different from 18% earnings growth and 26% dividend growth. Likewise, Value Line is predicting that the P/E ratio will fall to 16.0 over the next five years, which seems reasonable enough, since McDonald's is trading above its ten year historical P/E ratio without an indication that the future growth will be greater than the previous growth to justify the higher multiple.
My best guess is that McDonald's investors are going to experience 5-9% annual stock price growth over the medium term. The payout ratio has expanded from 20% to 50% over the past decade, and either that payout ratio will continue to increase, or the company's future dividend growth will correlate closer to the firm's earnings growth (I doubt the company will go the Altria (MO) route of paying 80% of earnings out as cash dividends), and the fact that the company is trading slightly above its 10 year average P/E ratio seems unwarranted given its likely return to high single digit growth rates.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
