McDonald's Corporation (MCD) is the largest hamburger restaurant in the world serving over 68 million customers daily in 119 countries around the world. Recently, McDonald's stock sold at a 52 week high of over $102 and since has fallen to below $90 per share. To help investors forecast MCD's potential return from a $90 stock price, I will use it in this example of how to forecast future returns on stock investments.
My basic formula for forecasting future returns, assuming a fixed market multiple, is:
Total Return = Earnings Growth + Dividend Yield
MCD's earnings growth for the next five years is forecast to be 9.7%. The current dividend yield is 3.1% based on its annualized dividend payment of $2.80 divided by a $90 stock price (3.1%=$2.80/$90). Assuming the market multiple of MCD stays fixed at its current 16.9 times earnings, the forecast total return of MCD would be 12.8%; calculated by adding its 9.7% forecasted earnings growth with its 3.1% current yield.
If investing were as simple as this basic formula, all you would need to do is add the earnings growth and dividend yield on all stocks and buy the one with the highest forecast total return. Obviously, there is more to investing than this basic formula or we would all be rich. Notice the assumption that the market multiple stays fixed. Ah, there's the catch. We need to forecast the future market multiple of the stock because an increasing market multiple will increase our future total return and a decreasing market multiple will lower our future total return. Therefore, a precise formula for forecasting future returns is:
Total Return = Earnings Growth + Dividend Yield + Multiple Change %
The market multiple is calculated by taking the current price of the stock and dividing by its earnings per share. For MCD, at a stock price of $90 per share and current earnings per share of $5.33, its current market multiple is 16.9 times earnings ($90/$5.33). How do we determine if the 16.9 times earnings market multiple for MCD is fair and what the multiple change may be?
One way to determine if the current multiple is fair on an investment is to compare its current multiple to its historic average market multiple (P/E). The 5 year average historic P/E of MCD is 19.6x. MCD's current multiple is 16.9x, at a stock price of $90, and is below its 5 year historical multiple of 19.6x. Another way to evaluate a stock's multiple is to compare it to the market, the multiple on the S&P 500 index. The current multiple of the S&P 500 index is 16.3 which is very close to the market multiple on MCD. Therefore, MCD's multiple does not look out of line to its historic multiple or the market multiple so the basic formula for forecasting future returns may be reasonable.
Even though the basic formula may be reasonable, let's test a couple of different scenarios. What if MCD's multiple expands by 3x to 19.9x, which is closer to its historic average of 19.6x over the next 5 years? Under this scenario, the total return on MCD's stock would increase from the basic formula's 12.8% to the precise formula's 16.1% because of the stock price increase caused by the change in multiple over the period. If MCD's multiple falls by 3x to 13.9x, the basic return would be reduced from 12.8% to 9.0% because of the reduced future stock price. To calculate the multiple change percentage for the precise formula, we need to calculate the compound annual growth rate (CAGR) for the price change using different multiples against the future earnings. Since this calculation gets a little complicated, the following table will give you an idea of the effect of multiple changes in a 5 year forecast.
OK, this has all been mathematical to this point. Therefore, can we just input the numbers into a computer model and determine the best investment for the next 5 years? No, there are many factors that affect market multiples that a computer cannot factor. For example, a faster growing stock will command a higher multiple than a slower growing stock. Therefore, if MCD's future earnings growth is lower than its past earnings growth, the market may reduce MCD's multiple. If management can grow earnings faster than the forecast, the multiple may increase. The multiple is also determined by the mood of investors, rising when investors are optimistic and falling when investors are pessimistic. So how do we minimize the effect of the multiple so we can be more confident in using the basic formula to calculate our future returns? The simplest answer is TIME.
To demonstrate the effect that time has on the total return in the precise formula, review the following table showing the effect of a -5x multiple change over various holding periods. Notice how time minimizes the effect of the change in multiple. The longer you hold a security, the less impact a change in market multiple will have on your results.
|1 yr||3 yr||5 yr||10 yr||15 yr||20 yr||25 yr||30 yr||40 yr||50 yr|
Hopefully, this exercise showed that you can't just buy the stocks with a single focus on dividend yield, earnings growth or P/E and be successful. You need to analyze the combination of all three factors. You need to be concerned whether management can deliver their forecast earnings and dividend growth and you need to estimate what multiple the market will pay for future earnings or hold the stock for a long period of time. After completing this analysis, only you can determine whether MCD is a good investment for your portfolio based on the projected returns and your confidence that management can deliver the forecasted growth.
My portfolio holds an equal weight investment in MCD. Therefore, I believe MCD is a good investment at $90 per share based upon the current assumptions of 9.8% earnings growth, 3.1% dividend yield and a market multiple of 16.9x compared to its historical multiple and the market's current multiple. If the current multiple continues into the future, a 12.8% total return can be expected. If the multiple falls by 3x, a 9.0% return can be expected. If the multiple increases by 3x, a 16.1% return can be expected. Since my plan is to hold MCD as a long term investment, the effect of a market multiple change is reduced, which increases the likelihood of receiving a return near the basic formula's projected return of 12.8%.