If you bought McDonald's (MCD) stock when it was $12 in 2003, you'd be a happy person today. Even without considering the dividends, McDonald's stock has annual return of 26% over the past nine years. That's better than any fund manager, Warren Buffett included, could dream of over a long term. Of course, hind sight is always 20/20. The question today is should you buy McDonald's today? Albeit a solid company with reasonable valuation, I do not think it's cheap enough at this price level.
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If one pays attention to McDonald's financial records, s/he'd be amazed that its revenue over the years has not changed that much (average less than 5% per year), but its profit was growing at a much faster pace on average at 26%.
The averages, however, can be misleading. A careful examination reveals that it was largely due to a big jump in 2008, when McDonald's cut its operating expenses by almost 50% (from $4,026 million in 2007 to $2,196 million in 2008). In recent years, McDonald's revenue and profit are both growing at a high single digit to low teen percentages. That is not an amazing growth pace. The following table provides McDonald's operating cash flow and free cash flow -- both lead to similar conclusions about McDonald's slow paced growth in recent years.
Operating Cash Flow
Free Cash Flow
At a price/earnings ratio of 18.86, McDonald's price seems a little high for its ~10% growth speed, even if you consider its 2.9% dividend. Its PEG ratio of 1.73 also indicates the same thing: it is not a cheap stock. The economic recovery may have some impact on McDonald's, but it is not expected to be a major driver for its profits. Its stock price barely budged during the financial crisis in 2008.
The story doesn't end here. In 2008, Altria (MO) split off its international business and formed a new company, Philip Morris International (PM). Philip Morris International pays out 3.4% dividend, has a P/E ratio of 18.35, and PEG ratio of 1.40, amazingly similar to McDonald's. If anything, Philip Morris International is a little cheaper than McDonald's in valuation, making it a slightly better long term holding. The following chart shows their stock price performance since Philip Morris International started listing as a separate company. Again, they follow very similar trends over time.
The similarity doesn't just stop there. Both McDonald's and Philip Morris have very strong brand names among consumers. According to Bloomberg BusinessWeek, McDonald's and Marlboro were number 8 and number 9 respectively in global brand value ranks. The strong brand recognition allows both companies to enjoy better profit margin than competitors.
To summarize, the two big consumer product/service giants, McDonald's and Philip Morris International, bear amazing similarity in their stock valuation and performance. At this price level, I believe both stocks are due for some correction or consolidation. If you have to hold just one, go for Philip Morris.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.