How To Value McDonald's

| About: McDonald's Corporation (MCD)
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Summary

There is a difference between being a successful investor and just wanting to be one: understanding value.

There are several ways to value a company. Find one that makes the most sense to you.

Here are the methods I use to value a company and what my current estimated valuation is for McDonald's.

Are you a successful investor?

This is more than just a rhetorical question. It is what defines how comfortably one will be able to retire or if s/he will be able to retire at all. As we all know it starts with saving. But what to do with those accumulated savings? Results are what defines success as an investor; not just short-term gains but those long-term compounded annual returns over a period of five years or more. Many money managers occasionally outperform the market indices like the Dow Jones Industrial average (NYSEARCA:DIA), the S&P 500 (NYSEARCA:SPY) or the Nasdaq (NASDAQ:QQQ), but very few can do so consistently, year after year. Fortunately for me, I have found a tool that helps me with that conundrum. I will share more about that later in the article.

My focus is on dividends since I am already of retirement age, having begun drawing my pension back in 2002. I retired early to allow myself the privilege of being involved in the raising of our two children. The plan was that I could do some consulting on the side out of our home and make enough to pay the bills. It worked and we were able to allow our retirement nest egg to grow. Many investors do not realize that over the very long term reinvested dividends make up over 40 percent of the total return on the S&P 500. Read that again. It is important to me and should be to you whether you need the income or not.

If you invest primarily in companies that do not pay a dividend you may be giving up a significant portion of the potential total return you could be achieving. When I was young I did not give a hoot about dividends and made more risky investments. I hit a few home runs but I also watched two of my holdings go through bankruptcy back after the dot com bubble burst. It was then that I become more conservative in my investing.

When the market becomes overvalued I hedge and accumulate more cash. I find that one of the keys to investing success is to limit losses. When the value of a portfolio falls by 50 percent one must double the remaining amount just to get back to even. When the market becomes undervalued I buy stocks of quality companies that have a consistent history of rising dividends, revenue growth and strong cash flows.

Valuation models to consider

There are plenty of valuation models to choose ranging from simple to highly complex. Generally speaking, the simple models have as few as one or two assumptions that the investor/analyst must decide upon (in reality, this is called guessing) to reflect future outcomes from the company and thus derive an estimate of fair value. The more complex models can require many assumptions which can also lead to either a much higher degree of accuracy or create far more opportunities for human error. As you might guess, I prefer the simpler models, but also use some moderately more complex models for validation.

As I have mentioned in the past, I like the DDM (dividend discount model) and the DCF (discounted cash flows) models. I also like to use the average historical P/E (price to earnings ratio) as a check. This would be a value based upon an earnings multiple approach. It can be argued, and rightfully so, that investors are paying now for the future earnings of a company. But the definition of "earnings" is getting harder to pin down as more than 90 percent of large capitalization companies now report non-GAAP EPS (earnings per share) instead of GAAP (generally accepted accounting principles) EPS. When I look up historical EPS for the S&P 500 by year I find tables from several different sources all with different numbers for each year. In aggregate, GAAP EPS are much lower than non-GAAP earnings and the gap between the two is rising. Therefore, I do not rely on any valuation that requires an input value for future earnings. Estimating the net present value of future free cash flow provides what I believe to be a much more reliable valuation for a company. Management and analysts can work magic with EPS, but free cash flow is hard to manipulate.

A little background

There are several reasons to consider McDonald's (NYSE:MCD) as a quality company. First is that it pays a very nice dividend currently yielding about 3.1 percent. That is well above the average for the S&P 500 index components in aggregate. The company has a good record of increasing its dividend. The last time the company cut its dividend was in 1994 when it dropped the quarterly dividend from $0.04 to $0.03. It has either risen or remained flat every year since. Of course, with the current quarterly dividend at $0.89, the compound average annual rate of increase has been an impressive 17.5 percent. There are also many more potential locations for future to expand globally. It may already operate in 118 countries already and be the number one food service organization in most of those markets, but it still serves less than one percent of the world's population.

On the flip side, there are some concerns. Revenue growth has slowed, especially domestically, and along with it the growth rate in dividend increases has also fallen dramatically. The latest increase was 3.5 percent (from $3.44 to $3.56), well below the long-term average. It is more likely that the long-term future increases will average closer to six percent than the historic long-term average, in my humble opinion. The company is maturing in most developed markets from which the bulk of its revenue comes and where the average income per capita is better suited to the MCD strategy. To illustrate this situation I have included the following chart showing the rate of change for same store sales. Offering breakfast all day is a good start toward reversing the trend, but the trend is decidedly sloping downward.

Chart from Business Insider

Overall, the company remains well situated to continue to grow into the future, albeit at a more moderate pace, and dividend growth investors may want to consider MCD for their portfolios whenever the stock price represents a good value.

Now I'd like to take a look at the company by the numbers and would like to do so primarily by using visual aids. The charts below tell a story so let us try to read what is being told. In the first chart, we take a look at EPS (earnings per share) and the annual rate of growth. From the low of $1.98 in 2007, EPS grew consistently to $5.55 per share in 2013. The next two years broke the string of sequential growth posting two years of falling EPS. But the TTM (trailing twelve months) number shows an improvement developing for the current year. The all-day breakfast menu is making a difference as is continued international expansion. But, one menu change will not continue to boost EPS consistently too far into the future. It remains to be seen if the relatively new leadership can keep making improvements year after year. They are off to a good start, though.

Chart by Mark Bern, CFA data source: oldschoolvalue.com

As mentioned above, the rate of dividend increases has slowed significantly, but that is primarily a function of capital allocation. Management could not justify raising the dividend by more when EPS was falling without allowing the payout ratio to get out of its target range. I suspect that management will be able to justify somewhat better increases in the future if it can get the revenue and earnings trends back on track. But I do not expect the future to hold double-digit increases.

Chart by Mark Bern, CFA data source: oldschoolvalue.com

The capital allocation process requires management must analyze its cash and allocate it efficiently to produce the best possible future results for shareholders; or, at least, that is how it should be done in theory. Of course, a portion of that cash flow must be allocated to capital expenses to maintain current operations, make them more efficient and to provide future growth in revenues and profitability. After removing that amount from operating cash flow, management must determine what is the best use of it FCF (free cash flow). For us to consider a company to be of high quality for investment purposes FCF must always be positive. MCD has a good record of producing FCF as illustrated below. FCF does not necessarily need to grow; it merely needs to stay positive. What the company does with its FCF is the important thing to consider.

Chart by Mark Bern, CFA data source: oldschoolvalue.com

Like many companies MCD has been buying back shares. This reduces the number of shares outstanding thereby increasing EPS by simply reducing the denominator of the ratio. It is often repeated by the financial press that buying back shares is a form of returning cash to shareholders. That notion makes sense in theory, but if the economy falls into recession revenues will likely drop as will earnings resulting in the share price falling as well. Holding excess cash has not seemed to hurt Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) or Apple (NASDAQ:AAPL). Buying back shares at record high prices does not make much sense. The only justification I can conjure is that companies are lowering their weighted average cost of capital. I would prefer to see companies investing in future growth in operations rather than accounting gimmicks to lock in stock options for executives. But I digress.

Chart by Mark Bern, CFA data source: oldschoolvalue.com

I find it interesting to look at the total of the amounts used for stock buybacks plus dividends paid compared to FCF on an annual basis. In the case of MCD it is apparent that every year since 2006 the FCF was not enough to cover buybacks and dividends. Thus, in each of those years, the company had to add debt. Interest rates on borrowing are very low and may never be this low again. I get that. The rate at which debt was rising through 2013 seemed reasonable since it was not altering the debt to total capital ratio appreciably. That story change some in 2014 and again, but much more dramatically, in 2015. Obviously (at least to me), management decided to retire more shares to prop up EPS. That is fine in the short term, but it could come back to haunt future company managers down the road.

Chart by Mark Bern, CFA data source: oldschoolvalue.com

Looking at the next chart shows up how much debt is being piled up by MCD. It was not a concern for me, really, until 2015. Long-term debt has increased by 74 percent since the end of 2014. The debt to equity ratio jumped from 1.16 at the end of fiscal year 2014 to 3.4 today.

Chart by Mark Bern, CFA data source: oldschoolvalue.com

The company has good management but the current trend leaves me with some reservations. A continuation of buybacks and increases of debt at the most recent levels would give me pause. This is not a reason to sell shares of the company, but rather it does give us something to keep an eye on.

How I value McDonald's

I start by using the simple method of valuing a dividend-paying company, the DDM (dividend discount model). I call it simple because there are only two assumptions: my required rate of return and my expected rate of future dividend increases. I could use a two-stage model, but since my holding period is relatively long I tend to stick with the single stage. My assumption for the long-term average compounded rate of dividend increases is six percent.

As to my required rate of return, a comment on my latest article about PepsiCo (NYSE:PEP) made me rethink what I should be expecting from mature companies in the consumer goods and services areas. I have generally desired a 12 percent compound annual rate of return. In the current environment, that may be unrealistic unless the market crashes (not completely out of the realm of possibilities). If the global economy (including the U.S.) falls into a recession I will likely increase my rate again. In the meantime, I have decided to drop the rate to ten percent. I am sure I will still get arguments from some that I should drop it further for valuation purposes. The problem is that I would not buy the stock for a lower expected return. I like some margin of safety in case things go awry.

My resulting valuation for MCD is $89.00. For those who are following and would like to know what the valuation for PEP would be using the ten percent rate of return, PEP would be worth $73.95.

One of the checks I use is to look at the average P/E (price to earnings) ratio over time and compare it to the current P/E ratio. The average P/E ratio in any given year has ranged from a low of 14.1 to a high of 21.8. By my calculation the overall average P/E ratio is 17.04. The current P/E ratio is 22.1. If I multiply the cost recent TTM EPS by the long-term average P/E the resulting valuation is $89.12. That is almost exactly what my DDM model tells me.

I use OSV (Old School Value), primarily for historical data, and as a way to check my valuations. OSV serves up three different valuation models: DCF, Graham's Formula (best used for cyclicals, companies with volatile cash flows and growth stocks) and EBIT multiples (a form of earnings multiple valuation). In the case of MCD, the DCF model is most appropriate. OSV values MCD at $83.09 per share which is also relatively close to my DDM valuation.

My favorite stock tool is Friedrich, partly because I spent so much time understanding its model and because it gives me a look back at ten years' worth of valuations and ratios all in one screen shot. It is also the most conservative of any stock tool that I have come across. It also uses a DCF model to value stocks and presents the output in two forms. The first is a table and the other is a chart. The table provides a quick look at ratios, valuations and trends over the last ten years. Here is the table for MCD.

Notice the current value for MCD is described as "Main Street Value" and stands at $97.72 as of the last update on August 28th. Again, that number may be higher but no too far off my own DDM value.

Source: AskFriedrich Datafiles

The chart below is also from Friedrich and illustrates that the current price (Wall Street Price) is trending flat to down while the fair value (Main Street Price) is rising. A few more strong quarters of growth could bring the two together which could bring MCD stock into view for a more detailed analysis and consideration.

Source: AskFriedrich Charts

Point - Counterpoint

Below are articles by other Seeking Alpha contributors. I like to offer readers points of view other than my own when considering an investment. The first link is to an article that seems more in line with my view. The second article is far more optimistic and the third is much more pessimistic.

"Here's What McDonald's Future Return Looks Like"

"McDonald's: Now Is A Great Time To Buy"

"25% Return In McDonald's In A Year?"

Summary

This is not a recommendation to buy or sell short shares of MCD. It is merely an illustration of how one more great company is not currently not offered at a great price. I believe the market, in general, to be overvalued by a significant margin which means that buying most stocks at current levels comes with far greater risk than under normal economic circumstances. You may be able to squeeze another five to ten percent out of a stock like MCD before the next economic downturn. Each investor needs to make such decisions on their own. I prefer to hold fewer positions in stocks when valuations are so rich. I do not believe that the potential reward warrants the level of risk I perceive to be attached to equity investing presently. There are very few companies that I can find that offer good value and appreciation potential over the next five years. I will write about those as well, interspersed among those companies, like MCD, that may be of quality but are not fairly priced.

There is the argument that low interest rates and low inflation justify the higher valuations. That is true for the moment. But those conditions are temporary and will not continue forever. I am a long-term investor. That means I want to buy and hold for more than five years, preferably for several decades. I expect a transition to a less accommodative economic reality over the coming five years and, for that reason, am holding fewer stocks than I have in a long time. I generally do not sell unless a stock price becomes overvalued by what I estimate to be 50 percent or more. I will look elsewhere for a better risk/reward opportunity. Patience is key to successful investing. It all comes back to the old adage of "Buy low and sell high." I will be buying sparingly over the next few years until the bargains I like become available again. When you get to be as old as I am, you know those opportunities will come along again. It only takes patience. It is easier said than done, I know, especially for the younger investors. I have been there, too. I wish I had had more patience in my youth; I would have accumulated far more wealth.

There is also the old adage that "Cash is Trash." But do not be fooled by that one. I hold most of my idle cash in the Vanguard GNMA Fund (MUTF:VFIIX) which yields 2.34 percent currently. In 2008, VFIIX provided a total return over seven percent while equities tumbled. When the market bottoms again and begins to turn higher I will have plenty of dry powder for shooting those bargain fish in the proverbial barrel.

For those interested in my valuation articles on other companies, you may consider becoming a follower of mine. If you would like to receive a notice whenever I publish a new article consider allowing the option to receive email alerts.

For those who would like to learn more about my investment philosophy please consider reading "How I Created My Own Portfolio Over a Lifetime."

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.

Disclosure: I/we 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.