McDonald's: Easy Business, Solid Dividends

Sep.27.12 | About: McDonald's Corporation (MCD)

Edited By Marianna Avilkina

McDonald's Corporation (NYSE:MCD) is the world's most well-known food service company, operating in more than 119 countries and serving nearly 50 million people every day. Founded in 1955, McDonald's has more than 30,000 locations around the world and consequently records the highest sales in the fast food industry. The hamburger company operates restaurants in both metropolitan and suburban areas, as well as at airports and other high traffic sites. Worldwide availability, affordable prices, and excellent services have made McDonald's one of the world's premier names in the fast food restaurant market.

As of September 26, 2012, MCD stock was trading at around $93, with a 52-week range of $83.74 - $102.22. It has a market cap of about $94 billion. The trailing twelve-month P/E ratio of 17.5 is higher than the forward P/E ratio of 15.6. P/B, P/S, and P/CF ratios stand at 6.7, 3.5, and 13.6, respectively. The operating margin is 31.5% while the net profit margin is 20%. The company's debt load is not an issue, with a debt/equity ratio of 0.9 that is far below the market average of 3.8.

McDonald's pays solid dividends - the trailing yield is 3.02%, whereas the forward one is 3.32%. Upcoming dividends are expected to amount to $.70 per share. Over the last five years, the company has gradually boosted its dividend amount by 87%. The five-year dividend history suggests that MCD is a strong dividend-growth company, as well as a stable dividend payer.

MCD has a 3-star rating from Morningstar. Out of six analysts covering the company, three have a "buy" rating, whereas the other three indicated a "hold" rating. This is good reason to suppose that Wall Street holds positive, yet diverse, opinions on the company's future. The average five-year annualized growth forecast estimate is 10%. What is the fair value of MCD given the forecast estimates? We can determine MCD's fair value using the discounted earnings plus equity model, as follows.

Discounted Earnings Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look intimidating for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.

E0 = EPS = ($5.32 + $5.96) / 2 = $5.64

Wall Street holds positive, yet diverse, opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 10%. Book value per share is $13.92. The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$5.64

V (t=1)

E0 (1+g)/(1+r)

$5.59

V (t=2)

E0((1+g)/(1+r))2

$5.54

V (t=3)

E0((1+g)/(1+r))3

$5.49

V (t=4)

E0((1+g)/(1+r))4

$5.44

V (t=5)

E0((1+g)/(1+r))5

$5.39

Disposal Value

E0(1+g)5/[r(1+r)5]

$49.00

Book Value

BV

$13.92

Fair Value Range

Lower Boundary

$82

Upper Boundary

$96

Minimum Potential

-12%

Maximum Potential

3%

Click to enlarge

(You can download FED+ Fair Value Estimator, here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my five-year discounted-earnings-plus-book-value model, the fair-value range for MCD is between $82 and $96 per share. At a price of about $93, MCD is trading at a price within its fair value range. The stock still has up to 3% upside potential to reach its fair value maximum.

Peer Performance

While there are many companies in the fast food industry, Yum! Brands, Inc. (NYSE:YUM) and Wendy's Co. (NASDAQ:WEN) are probably the closest competitors of McDonald's.

As my model suggests, overvalued Yum! Brands is trading at least 9% premium over the fair value, whereas MCD is fairly valued. In contrast to YUM, MCD follows a rather reasonable debt philosophy, with a relatively lower debt/equity rate. McDonald's offers a dividend yield almost twice as high as Yum Brands. Additionally, using funds invested by shareholders, MCD generates profits more than twice as low as YUM. However, McDonald's has the economic outlook comparably better in terms of dividend policy and prudent investment.

 

McDonald's

Yum Brands

Wendy's Co Class A

Trailing P/E

17.45

20.92

154.00

Forward P/E

15.58

17.84

24.32

Yield

3.02

1.71

1.73

Debt/Equity

0.9

1.4

0.7

Return on Equity

37.9

77.6

0.3

Click to enlarge

The other noteworthy competitor, Wendy's Co., is trading at an extremely high ttm P/E of 154. This key ratio is almost six times higher than the forward P/E, as well as eleven times higher than the market average. This fact suggests that buying Wendy's stock represents a more speculative investment. Furthermore, since 2008 Wendy's' quarterly dividends have decreased four times, from $.08 to $.02. In contrast to Wendy's, McDonald's obviously has a better economic outlook when it comes to investment profitability.

Current Economic Outlook

McDonald's Corporation has achieved the highest revenues in fast food sales, with products like hamburgers and Chicken McNuggets offered in its restaurants throughout the world. Starting with the U.S., MCD has diversified its services and products, thereby increasing sales and profits. While McDonald's' customer volume remains consistent in Europe, the number of customers has been increasing in the states. This results in impressive growth in the demand for the company's food and services.

Increasing its sales and profits, MCD performs efficiently and has followed a rising stock trend, when the 10-year history is reviewed. Since the start of 2012, the company's stock price has decreased by more than 6%. This decline is accompanied by challenges such as rising labor costs and an unpredictable economy. However, MCD keeps an eye on any potential difficulties to maintain a steady income growth going forward.

Summary

McDonald's future is very promising, given that the company has strategies to weather the current unstable economy. The above facts suggest that the share price can be expected to rise within a very near future. MCD has projected good future cash flows from the increasing sales the company is experiencing in its restaurants across the globe.

According to historical valuation metrics, MCD's stock is at a price within its fair value range. Based on the strength of its business activities, I expect McDonald's to continue outperforming its peers in the long run. Clearly, long-term investors can expect continued growth of dividends along with solid capital returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.