McDonald's Or IBM At $123?

| About: International Business (IBM)

Summary

A few years ago, shares of IBM were trading above $200, while shares of McDonald’s were under $100.

Recently, the two share prices “met” at about $123.

This article discusses which security you might prefer at that price.

At the time of this writing, shares of both McDonald's (NYSE:MCD) and IBM (NYSE:IBM) were exchanging hands around $123 per share. Now had you been told that both companies would be trading at the same price back in 2012, I'd suspect that you'd have a hard time believing it. During 2012, shares of IBM eclipsed $200 per share while shares of McDonald's regularly traded in the $90s and even high-$80s. The gap between the two share prices used to be substantial.

What's even more interesting, in my view, is the way in which each security got to where it sits today. Let's look back to the end of 2010 to make this idea clear.

At the end of 2010, IBM had just earned $11.50 per share or thereabouts. The share price was around $147, good for a trailing earnings multiple of just under 13. During 2015, IBM reported full-year earnings per share of $13.60 (closer to $15 in operating EPS). Even looking at the lower number, IBM grew earnings per share by 18% over the period. Yet, the share price during this time is now down 16%, resulting in a significantly lower earnings multiple.

Let's take a look at McDonald's. At the end of 2010, McDonald's had reported earnings of $4.60. The share price was around $77, resulting in an earnings multiple of about 17. Last year, McDonald's reported earnings per share of $4.80, or an increase of just 4%. Yet, during the same time, the share price is now up 60%.

This is the sort of thing that makes the investing world interesting and unpredictable. Someone could have told you the future operating figures and most investors would get the result wrong. Imagine someone came to you at the end of 2010 and said: "IBM trades at 13 P/E ratio and will grow earnings by 18%. McDonald's trades at a 17 P/E and will grow earnings by just 4%." Which would have looked more attractive? I'd contend that IBM would have looked substantially more attractive on those terms. Yet, shares of IBM declined 16% and shares of McDonald's increased 60%.

So here we are today: McDonald's trading at 26 times trailing earnings and IBM trading at 9 times trailing earnings, but both with effectively the same $123 share price. Given the choice (among thousands of others) to own 1 share of IBM or 1 share of McDonald's, which direction might you lean?

Naturally, the share prices reflect not just past performance, but also future expectations of profitability. To which point it'd be fair to suggest that McDonald's prospects, or at the very least the perception of such, are reasonably brighter at present. In other words, higher valuations can be justified by greater future performance.

Yet, this can still be an interesting case study. If you subscribe to the notion that investment results generally "catch up to" or "fall back to" business results, these two examples can provide a noteworthy exploration.

We're not going to settle which company is a better choice - the future is unknown. But it can nonetheless be helpful to work through the process. Let's start on the income side.

Income

Given the same current share prices, we don't have to worry about an even investment; we can just look at things on a per share basis. Presently, McDonald's pays a $0.89 quarterly dividend or $3.56 on an annual basis. IBM pays a $1.30 quarterly dividend or $5.20 on an annual basis. With both companies, you'd anticipate this amount to increase through the years.

If you're looking at a one-year time frame, IBM is the clear income winner. Unless you see a 46% dividend increase in McDonald's future (more than it made in profits last year), IBM at $123 will surely provide more income than McDonald's at $123 during the next year.

Once we lengthen our time horizon, the comparison becomes a bit more interesting. McDonald's is the underdog in this category, so we'll see what it takes to overtake IBM. If IBM were to keep the exact same $5.20 annual dividend, it would take McDonald's about four years of 10% dividend growth or closer to six years of 7% yearly growth to match the yearly payout. Of course, that's assuming that IBM doesn't grow its payout at all.

If IBM were to grow its payout by say 5% annually, it would take 10 years of 10% growth from McDonald's to eventually meet the same per share dividend payment. And that's just on an annual basis. On an aggregate basis, it's more like 15 years, and that's prior to considering being able to reinvest the higher dividend yield for the first decade and a half.

Moreover, IBM's payout ratio is considerably lower than McDonald's (about half). As such, I'd contend that it would be substantially difficult for a share of McDonald's to provide more income than a share of IBM any time soon. You might suspect faster earnings growth from McDonald's, but the higher starting yield and lower payout ratio leave ample room for IBM to continue to be the income winner.

Total Return

Of course, being the "income winner" certainly does not simultaneously indicate that a security must also provide higher total returns. It doesn't hurt, but it's not the whole picture.

I've seen annul growth rate estimates for McDonald's in the intermediate-term ranging from 4% to 9.5%. Let's scale that back slightly and call it 7% per year. After 10 years of this sort of growth, that would equate to a future EPS number of about $9.40.

We do not know what the future share price of McDonald's will be, but we do have a bit of history. Over the past decade, the average earnings multiple has been in the 16 to 17 range. Over the last five years or so, the average multiple has been around 18 times earnings, and just recently this mark jumped over 20. Let's use 18 - on the higher end of the historical range. After all, the company routinely traded with an average multiple of around 17 when it was growing at 10% annually. Here we're assuming slower growth and a higher multiple.

If shares traded at an 18 times earnings in a decade, with the above assumptions, this equates to a future price of about $170. If dividends were to grow in line with earnings, you might suspect that you would receive $49 or so in total dividend payments. In sum, you'd have a total expected value of about $219, or an annualized gain of just under 6%.

Now let's complete a similar exercise for IBM (and by the way, I don't yet know the end result, I'm approaching each with a cautious view). For IBM, I've seen estimated intermediate-term growth ranging from 0% to 7%. If the company were to make the same amount of profits a decade later, you'd still see some EPS growth due to share repurchases. Given that the company would now be buying shares under 10 times earnings, I think some sort of growth isn't an outlandish assumption - we'll call it 3%, less than half of that of McDonald's.

If IBM were able to grow earnings by 3% annually, this would equate to an EPS number of about $18.30 after a decade. Again, we don't know where shares will be priced, but we do have some history. Over the past decade, the earnings multiple has averaged about 13. During the last five years, this has been closer to 11, and recently it dipped below 10. Let's use 10 as a baseline.

In this case, the future share price would be about $183, already ahead of McDonald's. In addition, with just 3% annual dividend growth (despite the idea that there is a good deal room for more), you'd anticipate collecting $60 or so in dividend payments. Your total value would be roughly $243, good for an annualized return of about 7%. If you're just looking at growth rates, it's not intuitive that a slower growth rate could provide a greater benefit.

This is the sort of thing that makes the investing world interesting in my view. It's reasonable to place a higher valuation on companies you believe will be growing faster. Yet, it's paramount to understand how this valuation can interact with longer-term returns. I'd contend that the "investment bar" of McDonald's is now much higher, while the "investment bar" for IBM appears much lower.

Naturally, it doesn't have to work out this way. This is just one scenario out of an unlimited number of possibilities. Perhaps McDonald's grows by 12% or trades at 30 times earnings. Or perchance IBM doesn't grow at all. Anything is possible. Then again perhaps IBM does better than expected. It's times like these that present interesting case studies. Here you have a seemingly unlikely share price pairing - one way up and one way down - despite past EPS growth to the contrary. So, at $123 per share, which do you prefer: McDonald's or IBM?

Disclosure: I am/we are long IBM, 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.