McDonald's Offers +20% Upside With A 3.4% Dividend Yield

| About: McDonald's Corporation (MCD)

McDonald's Corporation (NYSE:MCD) franchises and operates McDonald's over 34,480 restaurants in 119 countries around the world. The company is a member of the S&P 500 dividend aristocrats, which are companies that have increased their dividend every year for the past 25 years or more.

Not only has McDonald's been able to consistently increase its dividend, but the rate of increase has been impressive, making this company a dividend growth investment stalwart.

Dividend History

Included below are the dividends and growth rates for the past decade, along with McDonald's payout ratio:

Year Dividend Dividend Growth Payout Ratio
2003 $0.4 -- 33.9%
2004 $0.55 38% 30.7%
2005 $0.67 22% 32.8%
2006 $1.00 49% 43.5%
2007 $1.50 50% 77.7%
2008 $1.63 9% 43.2%
2009 $2.05 26% 49.9%
2010 $2.26 10% 49.4%
2011 $2.53 12% 48%
2012 $2.87 13% 53.6%

Two things immediately jump out at me when seeing this historical data. First, McDonald's investors have been receiving double digit annual dividend growth every year of this past decade, except one. In 2008, when the financial crisis was unfolding across Wall Street, McDonald's stock still achieved ~9% growth in its dividend.

In fact, investors in McDonald's stock have a experienced a blistering 24% compound annual growth rate in the dividend over the 10-year period ending in 2012! Although the rate of increase has slowed considerably in more recent times, McDonald's dividend has still continued to grow at +15% CAGR during 2008-2012.

Second, although the payout ratio has grown, it has consistently been around ~50% for the past several years. This makes me feel more confident that the dividend growth investors have been experiencing is backed by improvements in earnings and the performance of the underlying company. And at 54%, the payout ratio is not too aggressive, and the company is probably still retaining enough capital to drive growth.

ROE & Future Growth

In addition to looking at historical growth and payout ratios for the dividend, analyzing McDonald's return on equity performance may also provide some clues as to what future dividend growth may look like.

On average, McDonald's has provided an average ROE of 35% over the past 5-years (2008-2012).

MCD Return on Equity (<a href=TTM) Chart">

MCD Return on Equity (TTM) data by YCharts

Using a "back of the envelope" approach, we can use the payout ratio and ROE to estimate future earnings growth. In other words, McDonald's is retaining ~46% of earnings, and is earning ~35% on its equity, so holding these numbers constant would give you an estimate of 16% earnings growth going into the future.

Again, this is simply a rough estimate that we can compare to our historical numbers. This type of calculation will only take into account the retained earnings (equity), but ignore any debt issuance, stock issuance, or changes in how McDonald's capital structure. Furthermore, it will not take into account capital returned to investors through stock repurchases. So there are numerous limitations. However, it does show that earnings and dividends could continue to grow at a double digit in theory, as our historical trend suggests.

Recent Dividend Announcement

McDonald's recently announced another dividend increase for 2013, raising the quarterly cash dividend to $0.81 from $0.77. While this is only a 5% increase on a quarter-to-quarter comparison, the new quarterly dividend raises the estimated annual dividend to $3.12 for 2013. This represents a ~9% increase compared to McDonald's 2012 dividend, which seems more inline with the past.

Dividend Discount Model

Using the dividend discount model, I determined the value of the company based on its future dividend payments. In performing this valuation, I made several assumptions.

  • First, I used 8% as my discount rate, based on the long-term average return of the stock market
  • Next, I used McDonald's estimated 2013 dividend as the base to apply future growth rates to, taking into account the dividend increase the company announced in September
  • I applied a 15% growth rate for the next 2-years (2014 & 2015), a 12% growth rate for 2016-18, and then a 1% sequential decline starting at 10% in 2019 (2020=9%, 2021=8%, etc.) through 2023.
  • Finally, I assumed a 3% perpetuity rate after 2023

Based on these assumptions, I calculated that McDonald's intrinsic value is ~$120 per share. At the current price of $96.03/share, the stock is ~25% below its intrinsic value. Hence, the current price offers investors a large margin of safety for a blue-chip company with a long track record.

Furthermore, the market is pricing in a 4.5% constant annual growth rate in the dividend going forward, based on the current stock price and assuming a 1-year increase of 15%. This seems particularly low considering McDonald's historical dividend growth, recent dividend increase amount and the strength of the company.

Both of these observations makes the downside potential from an investment in McDonald's stock seem limited, from a dividend growth investor's perspective, as the market seems to be pricing in much lower dividend growth than the company has previously provided. Therefore, long-term, income-oriented investors may want to conduct further research on McDonald's to see if it should be included in their portfolio.

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.

Additional disclosure: 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 dividend 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.

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