In this article, I will run you through my DCF model on McDonald's (MCD) and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared with Wendy's (WEN) and Yum! Brands (YUM). I will also argue that concerns about "overly high" (whatever that means) executive compensation is not just overblown, but almost completely wrong. That is to say, greater executive compensation (not less) adds value. I find that McDonald's is appropriately valued by the market right now, but remains a safe dividend stock due to its attractive brand (which is in large part reinforced by favorable executive compensation).
First, let's begin with an assumption about the top-line. McDonald's finished FY2011 with $27B in revenue, which represented a 12.2% gain off of the preceding year. I model revenue trending from 5% to 10% over the next 6 years.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures and taxes. I model cost of goods sold eating 60.5% of revenue versus 9.3% for SG&A and 9% for capex. Taxes are estimated at 30% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital. I expect that this will hover around -0.5% of revenue over the projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 7% yields a fair value figure of $100.58 - basically in-line with the market's current assessment.
All of this falls within the context of strong performance:
I'm pleased to report a strong fourth quarter and another strong year for McDonald's in 2011. System-wide sales increased 7% in constant currencies, with global comparable sales up 5.6%, marking our eighth consecutive year of positive comp sales growth in every area of the world.
We closed the year on a high note with fourth quarter comp sales up 7.5%, the highest quarter in over 7 years, and December comp sales at 9.6%, reflecting positive momentum and a weather benefit in Europe and the U.S. This momentum continues as we begin 2012, with global comparable sales for January expected to be up 5.5% to 6.5%.
As has already been made clear, Jim Skinner, the successful CEO, of the company is retiring. In 2009, his earned $17.57M. If the company were to distribute his earnings back to shareholders, they would get less than 2 cents per share owned. Put differently, if you had a $1M stake in the company, you would receive a check worth just short of $175. In short, compensation has virtually no impact on the company's net earning power - the main source in which it is valued.
On the other hand, it has a significant impact on building a brand and motivating management. Behavioral economics suggests that bulls will be attracted to companies that are willing, and capable, of paying management top dollar.
From a multiples perspective, McDonald's is just where it should be. It trades at a respective 18.7x and 15.6x past and forward earnings versus 22.7x forward earnings for Wendy's and 18.8x forward earnings for Yum!. Assuming a multiple of 18x and a conservative 2012 EPS of $5.66, the rough intrinsic value of the stock is $101.88 - virtually in-line with my DCF result. With a dividend yield of 2.8% and nearly 60% less volatility than broader indexes, McDonald's is a safe income play.
Consensus estimates for Wendy's EPS forecast that it will grow by 20% to $0.18 in 2012 and then by 27.8% and 8.7% in the following two years. The stock is highly risky considering that it trades at 20x its 2014 EPS estimate. If McDonald's traded for this amount, it would be worth $139 per share - about 41% of its current valuation. Yes, Wendy's may have stronger growth; but, this is a huge bet with significant downside for a company that is basically just as volatile as the broader economy.
Consensus estimates for Yum!'s EPS forecast that it will grow by 14.3% to $3.28 in 2012 and then by 14.6% and 16.5% in the following two years. Assuming a multiple of 18x and a conservative 2013 EPS of $3.73, the rough intrinsic value of the stock is $67.14, implying 5% downside. Yum! may have an attractive portfolio of brands and nice leverage in China, but McDonald's is a more favorable name during these uncertain economic times. If multiples shrink, the stock would take a significant hit.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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