Read This Before You Sell McDonald's

| About: McDonald's Corporation (MCD)

Summary

McDonald’s share price has increased significantly as of late.

With shares trading above their average historical valuation, many investors have considered selling.

This article gives you some things to think about prior to making that decision.

If you want to sell your shares of McDonald's (NYSE:MCD) ,don't let me stop you. However, before you do so, I would first consider the strategies described herein.

Between the end of 2011 and September of 2015 the share price of McDonald's did basically nothing. Actually less than that, declining slightly from $100 to $99. You would have received dividends along the way, but your total return would have been somewhat uninspiring. (Although to be sure, this stagnating share price created a benefit for the long-term net buyer.)

During the last six months, shares have gone from $99 all the way up to $128 -- a 29% increase -- which nicely demonstrates the idea that pricing bids can occur in spurts. Here you had years with the same and even lower prices, only to see a materially higher price just recently.

For the past couple of decades McDonald's average earnings multiple has been in the high-teens. Based on reported earnings around $4.80 per share last year, the current market quotation equates to a trailing multiple of nearly 27. This idea alone, especially when coupled with a much higher recent share price, might have some investors inclined to sell and perhaps replace their holding with another security.

This may or may not be a reasonable consideration. So before making a rash decision, I think it can be helpful to consider a variety of different items.

Come Up With A Baseline

Prior to thinking about selling, I'd contend that you have to know (more or less) what you believe is a "fair" price to pay. If not $128, then what? If you can't answer this question, then you don't really know if $128 is too high or low, even based on your own expectations. So let's come up with a baseline.

Incidentally, I have previously provided an illustration similar to this so we can piggy-back off of that example. McDonald's is expected to generate around $6 per share by 2017 and have an earnings growth rate around 10%. If this were to come to fruition, you might anticipate earnings-per-share to reach $8 in five years' time.

The company's historical earnings multiple has been in the 17 to 19 range. At 18 times earnings, you'd anticipate a future share price of around $144. Should the dividend payment grow in line with earnings, you might also anticipate receiving $24 in per share dividend payments, good for a total value of about $168.

Now obviously what actually occurs could be much higher or lower, but remember we're just creating a baseline. Based on a current share price of $128, these assumptions indicate a total annualized gain of about 5.6%.

So that's the first test. You have to think about whether or not a 5.6% annual return would be a reasonable result for you. This doesn't guarantee that it will happen, but it does inject a bit of logic into your process. If you're happy with that potential outcome, it's rational to continue holding your shares.

If instead you think, "gee, I think I could meet or exceed that potential return with another security" that's a logical reason to think about selling. However, before you do, there are a few more hurdles that you must clear.

The Quality Of The Business

A lot of people like to give McDonald's flak for being an unhealthy burger joint, but the company remains a very profitable enterprise that has increased its dividend for decades. When you think about selling, you have to also think about whether or not you can find an investment of similar or better quality. Especially in the long term, straying from quality could be a dangerous direction to go.

Frictional Expenses

A third hurdle that you have to clear is whether or not you can find a better security, of similar or higher quality, that also remains better once you add in the frictional expenses. You obviously have the transaction costs, but you might also face taxes if you hold the security in a taxable account. So not only does the other security have to look more attractive than McDonald's side-by-side, it also has to look perhaps 10% or 30% better to clear the hurdle of expenses incurred.

The Possibility Of Being Wrong

In the above illustration, we used very specific assumptions that gave us a very specific expected return. Yet none of that is known. It could be that our growth rate or P/E ratio was too low, or any number of additional possibilities. To account for this, I find it prudent to create a range of scenarios:

Click to enlarge

In the above table I have illustrated a potential growth rate across the top row to go along with potential future P/E ratios moving down the first column. The dividend is expected to growth in line with earnings in this example. The values that you get by looking at a cross section indicate the potential annualized gain based on each set of assumptions.

Let's do a "for instance." Suppose you have a minimum expected return requirement of 8% for McDonald's. If we look at the cross section of 10% growth and a future P/E ratio of 18, we can see that this would equate to an anticipated total return of about 5% per year. (Note that this varies slightly from the example above in that this table presumes growth off of the $4.80 base, whereas before we assumed EPS of $6 by 2017.) So if this was your baseline, you would anticipate annual returns around 5% and perhaps still consider selling if you believed you could find another security that could also clear the additional hurdles.

Naturally if McDonald's grows slower or traded with a lower multiple in the future, your expected return is apt to be even lower.

However, you must also consider the possibility of being wrong. There's a possibility that McDonald's grows by 12% or else trades above 22 times earnings. Personally I like to remain prudent in these assumptions, but it is nonetheless a possibility. You could throw away a perfectly good security just to see it continue to perform quite well.

So it's not enough to see that McDonald's share price is higher and then say, "well I guess it's time to sell." There's more to it than that (even beyond what I've done here). Not only do you have to create a baseline that suggests your future returns may not be adequate. You also have to clear the hurdles of finding a quality replacement, level of income, beat the frictional expenses and consider the possibility of being wrong. This is a much higher test than, "McDonald's is trading at its 52-week high."

If you can answer of those questions and you still want to sell, that's a perfectly rational conclusion to make. In coming upon that sentiment, you have a few alternatives. You could sell your shares outright; just place a market order. Or you could make an agreement to sell at today's price or an even higher price in the future.

As an illustration, at the time of this writing you could sell a January 20th 2017 call option with a $130 strike price for $6.00. (Note: I have no affinity for this date, it just makes an example easy to see.) This means that if you were to agree to sell 100 shares of McDonald's at a 1.5% higher price, you'd receive $600 for doing so.

One of two things happens in this scenario: either the option is exercised or it is not. If the option is not exercised, as would likely be the case if the share price remained below $130, you keep your shares of McDonald's and continue to collect your dividend payments. You also received an upfront cash flow of 4.7% (which may be taxed differently than dividends). The benefit is that the return would be greater than holding shares alone. The "downside" is that you may not sell your shares this way (and they could be much lower), but that sort of nets out a bit in that you still collect a higher return.

If the option is exercised, you still have your upfront premium and would receive net proceeds of ~$13,000 (less frictional expenses, plus the starting premium) to redeploy as you see fit. This is better than selling at $128 outright, although you would need to be cognizant of the time value of money and the potential psychological pressure associated with agreeing to sell at $130 only to see shares go much higher.

And naturally there are many more agreements out there. You could agree to sell at $140 with the same expiration date and collect an additional 1.9% worth of cash flow instead, as an example.

In short, McDonald's share price has moved materially higher in the last few months and is now trading well above its average historical valuation. Some may see this as an automatic consideration to sell, but I would contend there is a bit more to it than that. First, you have to come up with a baseline for what you believe is a "fair" price. This isn't going to perfect, but it will add some logic to your decision. From there, you also have to clear the additional hurdles of quality, income, frictional expenses and considering the possibility that you may be wrong. If you've completed those items and still want to sell, it can be useful to explore what options are available to you.

Disclosure: I am/we are long 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.