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Shares of McDonald's (NYSE:MCD) have returned only 3.96% over the past 12 months primarily attributable to the company's sluggish growth in the European markets. The stock touched its 52-week low at $85.95 in June and has already recovered by 9% since then. At $93.50 per share, MCD offers an attractive dividend yield of 3.0%, which is considered to be lofty in the fast-food sector. Together with the stock's reasonable valuations as well as the company's commitment and financial strength to return capital to shareholders, MCD should deserve a spot in your core investment portfolio. The following is the analysis to support my bullish opinion.

McDonald's is priced somewhat below its intrinsic value relative to the firm's financial performance (see table below). Comparing to a peer group consisting of McDonald's primary competitors such as Yum! Brands (NYSE:YUM) and Wendy's (NASDAQ:WEN), growth potential appears to be MCD's primary weakness. Analysts on average predict McDonald's revenue, EBITDA, and EPS to rise by 2-year CAGRs of 3.8%, 5.0%, and 6.4% over the current and next fiscal years. The estimates are largely below the peer averages of 7.7%, 12.6%, and 31.2%, respectively. Also, McDonald's EBITDA margin is forecasted to expand by just 0.9%, compared to the peer average of 1.5%. However, McDonald's is more profitable. All of the company's margin and capital return measures are significantly above the peer averages, and it is noted that McDonald's net profit margin of 20.0% almost doubles YUM's second highest profit margin at only 11.9%. In terms of leverage and liquidity, MCD assumes an in-line debt level as reflected by the firm's higher debt to capitalization ratio but lower debt to EBITDA multiple. The robust free cash flow generation is another bright spot for McDonald's. The firm's LTM free cash flow margin at 12.9% is only behind that of Dunkin' Brands (NASDAQ:DNKN). McDonald's interest coverage ratio and current ratio are slightly below the averages, but it has a higher current ratio, reflecting a fairly healthy balance sheet.

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In summary of the financial comparisons, the slower growth prospects appear to be the company's main weakness, and it would not be surprised to see the stock trade at a small valuation discount to account for the fact. Nevertheless, McDonald's current valuations at 10.5x LTM EV/EBITDA, 27.3x LTM EV/FCF, and 17.6x LTM P/E actually represent a sizable valuation discount of 29% over the peer-average multiples (see table above), suggesting that the stock is somewhat undervalued.

Accounting for the earnings growth, McDonald's trades at a NTM PEG of 1.76x, which is higher than the peer average at 1.41x (see table above). Although the PEG valuation appears to be pricey, McDonald's PEG actually trades almost the same as S&P 500 indices' 1.76x PEG. It should be noted that according to Capital IQ, MCD carries a higher estimated long-term earnings growth rate at 9.44%, compared to S&P 500 companies' average at 7.85%.

Moreover, McDonald's current valuation is fairly in line with its historical level. The company's LTM EV/EBITDA and LTM P/E multiples are trading fairly close to their 3-year historical averages (see charts below).

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Over the past 12 months, McDonald's LTM P/E multiple has almost converged to the level of the Dow Jones Industrial Average index and the S&P 500 index, which was largely below the company's P/E multiple in a year ago (see chart below).

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McDonald's valuation appears to be weighed by investors' concern on the firm's European growth. I believe the worrisome is exaggerated as the company has an array of plans to revitalize the growth in the European continent. Deutsche Bank's analyst, Jason West, wrote the following comment in his recent research note:

"On Sept 12-13, we attended MCD's investor events in Germany and Poland. We met with local management, as well as CEO Don Thompson, COO Tim Fenton, and President of Europe Doug Goare. We came away with a better appreciation of both the opportunities and challenges in Europe, which represents nearly 40% of MCD's profits. While commentary around Europe macro trends and cost inflation was a bit worse than we had expected, MCD seems to have a better handle on the Europe headwinds than 5-6 months ago. Plus, the company's dominant competitive positioning, superior assets, and array of sales drivers (breakfast, reimaging, value, McCafe) give us confidence that it can minimize the downside risk in this market, particularly given already-low investor expectations. With ~10% long-term EPS growth, plus a 3%+ dividend yield, we believe the current multiple (15x 2013E) is attractive. Buy."

On top of the favorable valuation, McDonald's also offers a 3.0% dividend yield, which is safely backed by the company's quality dividend policy and ample financial resource. Over the past decade, dividend per share has been raised steadily by a significant 10-year CAGR of 27% from $0.23 in FY2001 to $2.53 in FY2011 (see chart below). In addition, historically, McDonald's annual dividend paid only represented a portion of the annual free cash flow (see chart below), implying that there is ample room for future dividend growth and the share buyback will likely continue.

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In conclusion, I recommend acquiring the shares in light of the attractive valuations and dividend yield, which help establish a solid margin of safety on the investment. Assuming the LTM P/E multiple stays at the 3-year average of 17.1x and EPS grows to $5.96 in a year according to analysts' average estimate, the 1-year price target would be $102.

Comparable analysis table is created by author, all other charts are sourced from Capital IQ, and all financial data is sourced from Morningstar, Thomson One, and Capital IQ.

Source: McDonald's: Love The Stock's Margin Of Safety