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McDonald's (MCD) runs over 33,000 restaurants worldwide, 80% of which are independently owned and operated by franchisees. Revenue of $27 billion dwarfs that of competitors: Wendy's (WEN) with $2.4 billion, Jack in the Box (JACK) with $2.2 billion, and Yum Brands (YUM) with $12.6 billion.

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McDonald's stock has been unstoppable over the last few years, roughly doubling over three years. McDonald's 5-year financials are listed below.

(In Million $)20072008200920102011
Revenue$22,786$23,522$22,744$24,074$27,006
Operating Cash Flow$4,876$5,917$5,751$6,341$7,150
Capital Expenditure$-1,947$-2,136$-1,953$-2,136$-2,730
Free Cash Flow$2,929$3,781$3,798$4,206$4,420

Revenue has grown 18.5% from 2007 to 2011, while free cash flow has grown by over 50% in the same time period, reflecting an increase in margins.

Owner Earnings

Owner Earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner Earnings as follows:

These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.

I'll calculate Owner Earnings by taking the 5-year average capital expenditure and subtracting that from the operating cash flow. I'll also subtract stock-based compensation from the operating cash flow, since it has a dilutive effect on the company, but is routinely included in the cash flow figure. I'll also add interest payments adjusted for taxes since interest is tax deductible.

(In Million $)20072008200920102011
Operating Cash Flow$4,876$5,917$5,751$6,341$7,150
Interest Payments$410$522$473$450$492
Stock-based Comp.$142$112$112$83$86
Avg Capital Expenditure$-2,180$-2,180$-2,180$-2,180$-2,180
Owner Earnings$2,964$4,103$3,902$4,480$5,308


Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the Owner Earnings figures to determine McDonalds's Cash Return on Invested Capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the Owner Earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which is a poor measure of profitability.

(In Million $)20072008200920102011
Owner Earnings$2,964$4,103$3,902$4,480$5,308
Invested Capital$29,391$28,461$30,224$31,975$32,989
CROIC10.09%14.42%12.91%14.01%16.09%

McDonald's CROIC was 16% in 2011, which means that given, say, $1 million of invested capital (retained earnings for example) the company will generate $160,090 in cash on that invested capital. In the long-term a company should grow at roughly it's CROIC. McDonald's is clearly an efficient company in terms of cash generation. Let's take a look at the balance sheet.

Cash and Cash Equivalents$2,335
Investments$1,427
Debt$12,500
Pension Obligations$0
Minority Interest$0
Net Cash (Debt)$-8,738
Diluted Float1,041
Cash/Share$-8.39

McDonald's has over $12 billion in debt with net debt of $-8.39 per share. Interest payments are less than 10% of owners earnings, so this debt is not a concern.

Valuation

I use a discounted cash flow analysis to put a fair value on a company. I use a discount rate of 15%, and you can read about my view on discount rates here. I will use an initial growth rate of 13%, which is in line with the historical CROIC, and let that growth rate decay to 3% over 20 years, which will then be the perpetual growth rate. The owner earnings growth schedule is displayed below.

Year12345678910
%13%12.5%12%11.5%11%10.5%10%9.5%9%8.5%
Year11121314151617181920
%8%7.5%7%6.5%6%5.5%5%4.5%4%3.5%

Using these parameters I arrive at a fair value of $71.46, which is significantly below the current market price of around $100. Buy targets for various margins of safety are listed below.

Margin of SafetyBuy Target
10%$64.31
15%$60.74
20%$57.17
25%$53.59

Conclusion

McDonald's the stock seems to be ahead of McDonald's the company. It would seem that one of two things will happen at some point in the future: The stock price will fall back to reasonable levels or it will stagnate until the company catches up. McDonald's is a fantastic company in terms of profitability, efficiency, and growth prospects, but it is by no means a value at current prices.

Source: McDonald's The Stock Is Ahead Of McDonald's The Company