McDonald's Back In Value, Above Average Growth And Yield

May.14.12 | About: McDonald's Corporation (MCD)

McDonald's (NYSE:MCD) is a great favorite of the dividend growth investor. However, Mr. Market knows this and has historically applied a premium valuation to this blue-chip dividend stalwart. Due to its consistently above-average earnings growth, McDonald's is a company that you could even pay a little too much for and still make money over the long run through dividend increases and capital appreciation. At its current valuation, McDonald's sits at the high end of its valuation range. Therefore, although it is not a screaming bargain, today's valuation represents a sound valuation given McDonald's quality and consistency.

Dividend Champion: McDonald's Corp

This article looks at McDonald's Corp, a Dividend Champion, through the lens of our graphs. Since a picture is worth a thousand words, the reader will be provided the "essential fundamentals at a glance" expressed vividly in pictures. In order to provide you the opportunity to research this company deeper and faster we are providing a link to a live, fully functioning earnings and price correlated set of graphs Found Here. (Tip: Run your mouse over the various lines and watch the graphs come to life).

A Dividend Champion is defined as a company that has increased its dividend every year for 25 or more straight years. McDonald's Corp is a Dividend Champion that has raised its dividend every year for 35 consecutive years. The complete Dividend Champions list is compiled courtesy of David Fish. (Open as an excel spreadsheet and look at the tabs on the bottom to find the Dividend Champions list).

About McDonald's Corp: from their website

"McDonald's is the world's leading global foodservice retailer with more than 33,500 locations serving approximately 68 million customers in 119 countries each day. More than 80 percent of McDonald's restaurants worldwide are owned and operated by independent local men and women."

McDonald's Corp: A Dividend Champion with 35 Consecutive Years of Dividend Increases

Learning from the Past - Looking at Earnings Only

Since dividends are paid out of earnings, a clear perspective of a company's historical earnings growth record is a vital component of a dividend investor's prudent due diligence process. The following graph plots McDonald's Corp's earnings per share since 1998. A quick glance to the right of the graph shows that McDonald's Corp has increased earnings at a compounded rate of 11.1% (see purple circle on graph) per annum.


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Earnings Determine Market Price and Dividend Income: The following earnings and price correlated graphs clearly illustrates the importance of earnings to both price movement and dividend income. The earnings growth rate line or True Worth ™ line (orange line with white triangles) is correlated with the historical stock price line. On graph after graph the lines will move in tandem. If the stock price strays away from the earnings line (over or under), inevitably it will come back to earnings.

Since dividends are paid out of earnings, and therefore represent additional return on top of what the market capitalizes earnings at, they are depicted by the light blue shaded area and stacked on top of the earnings line. Therefore, a quick visual of these two important components is simultaneously revealed:

1. The additional return that dividend paying stocks provide.

2. The percentage of earnings paid to shareholders as dividends (payout ratio).

The value in this article is through carefully analyzing the earnings and price correlated fundamentally based graphs. Notice that one glance tells you how well the company has performed on an operating basis historically and how the market valued that historical performance. Therefore, the reader is free to discover whether or not current valuations make sense based on historical norms coupled with fundamental values. Instead of opinion, this article is designed to produce facts that can be analyzed to the readers investing benefit.

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Performance Table: Capital Appreciation and Dividend Income McDonald's Corp

The associated performance results, with the earnings and price correlated graph, validates the above discussion regarding the two components of total return: Capital appreciation and dividend income. Dividends are included in the total return calculation and are assumed paid, but not reinvested.

When presented separately like this, the additional rate of return a dividend paying stock produces for shareholders becomes undeniably evident. In addition to the 9.8% capital appreciation (Closing Annualized ROR), long-term shareholders of McDonald's Corp would have received an additional $57,087.47 in dividends that increased their total return from 9.8% to 10.9% per annum.

(Note: Since this is a Dividend Champion it has raised its dividend every year for at least 25 years, therefore, negative dividend growth rates shown, if any, will be attributed to special additional dividends paid in excess of the company's regularly reported dividend rate)

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The following graph plots the historically normal PE ratio (the dark blue line) correlated with 10-year Treasury note interest. Notice that the current price earnings ratio on this quality company is as normal as it has been since 1998.

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A further indication of valuation can be seen by examining a company's current price to sales ratio relative to its historical price to sales ratio. The current price to sales ratio for McDonald's Corp is 3.40, which is historically normal.

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Looking to the Future

Extensive research has provided a preponderance of conclusive evidence that future long-term returns, and the dividend and its growth rate are a function of two critical determinants:

1. The rate of change (growth rate) of the company's earnings

2. The price or valuation you pay to buy those earnings

Therefore, forecasting future earnings growth, bought at sound valuations, is the key to safe, sound, and profitable performance.

Therefore, it logically follows that measuring performance without simultaneously measuring valuation is a job half done. At its current price, which is attractively aligned with its True Worth™ valuation, McDonald's Corp represents a potential opportunity to invest in a Dividend Champion at a reasonable price. The important factor is that McDonald's Corp has real assets and cash flow underpinning its stock price. This solid economic foundation offers shareholders the potential for both a strong margin of safety and an opportunity for an increasing dividend income stream and potentially attractive future returns.

The Estimated Earnings and Return Calculator Tool is a simple yet powerful resource that empowers the user to calculate and run various investing scenarios that generate precise rate of return potentialities. Thinking the investment through to its logical conclusion is an important component towards making sound and prudent commonsense investing decisions.

The consensus of 27 leading analysts reporting to Capital IQ forecast McDonald's Corp long-term earnings growth at 10%. McDonald's Corp has medium long-term debt at 46% of capital. McDonald's Corp is currently trading at a P/E of 16.8, which is inside the value corridor (defined by the five orange lines) of a maximum P/E of 18. If the earnings materialize as forecast, McDonald's Corp's True Worth valuation would be $138.36 at the end of 2017, which would be a 10.3% annual rate of return from the current price, including assumed dividends.

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Earnings Yield Estimates

Discounted Future Cash Flows: All companies derive their value from the future cash flows (earnings) they are capable of generating for their stakeholders over time. Therefore, because Earnings Determine Market Price and dividend income in the long run, we expect the future earnings of a company to justify the price we pay.

Since all investments potentially compete with all other investments, it is useful to compare investing in any prospective company to that of a comparable investment in low risk Treasury bonds. Comparing an investment in McDonald's Corp to an equal investment in 10-year Treasury bonds illustrates that McDonald's Corp's expected earnings would be 5.7 times that of the 10-Year T-Bond Interest. (See EYE chart below). This is the essence of the importance of proper valuation as a critical investing component.

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This report presents essential "fundamentals at a glance" on Dividend Champion McDonald's Corp, illustrating the past and present valuation based on earnings achievements as reported. Future forecasts for earnings growth are based on the consensus of leading analysts. Although with just a quick glance you can know a lot about the company, it's imperative that the reader conduct his or her own due diligence in order to validate whether the consensus estimates seem reasonable or not.

Summary & Conclusions

McDonald's represents an excellent choice for the prudent dividend growth investor seeking both capital appreciation, and above-average current yield and the opportunity to grow both in the future. With its recent pull-back, McDonald's is priced at the upper end of our valuation corridor. Therefore, although the company is not cheap, we do consider it a sound long-term investment at these levels. Furthermore, we would suggest that if the stock continued to drop from these levels, the prudent investor could use the lower price as an opportunity to average down their cost basis. As always, we recommend you conduct your own thorough due diligence.

Disclosure: I am long MCD.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation. A comprehensive due diligence effort is recommended.