McDonald's Corporation (NYSE:MCD) is synonymous with successful restaurants and even developed the business model that just about every other restaurant company uses: the franchise. McDonald's is now one of the largest restaurant companies in the world with over 36,000 locations across the globe.
The franchise business model that McDonald's employs is very straightforward. McDonald's owns the restaurant, charges the franchisee rent and gets a percentage of revenues from each franchised restaurant. That's how over 80% of McDonald's locations worldwide are run.
McDonald's is currently in the midst of a turnaround plan to get the company back on a growth track. The business has struggled in recent years as consumers have desired healthier options forcing McDonald's to shift direction to get customers back to their restaurants.
However, just because McDonald's has been a wonderful investment in the past doesn't necessarily mean that they will do well in the future. The problem is that investing is all about the relation between the share price and the value of the underlying business. A great company can be a bad investment if the valuation is out of whack. Let's examine what kind of return potential McDonald's has at the current price of $114.09.
One of the first factors I look at before investing in a company is their dividend history. That's a quick screen that allows investors to narrow down the universe of high quality companies. The longer the streak of growing dividends the better. This doesn't necessarily mean that every company you find will be great; however, I'd say that there's a much higher likelihood of finding one here if you could only look at one metric.
McDonald's has done and excellent job rewarding shareholders with higher dividends. In fact, just last month they gave owners a 5.6% pay raise and 2016 will mark the 41st consecutive year of higher dividend payments. That gives them the title of Dividend Champion.
*Image source: Author. Data Source: McDonald's Corporation Investor Relations.
**An interactive version of this chart can be found here.
It might look like McDonald's dividend payments have fluctuated significantly; however, I assure you they haven't. From 1976 through 1999, McDonald's made quarterly payments, then switched to annual from 2000 through 2007 and have paid quarterly since 2008. The annual payments have in fact risen every single year since 1976.
The greatest company in the world can make for a bad investment if the stock price is significantly higher than the value of the underlying business. Whenever you make an investment, or evaluate whether one deserves to remain in your portfolio, it doesn't matter what a company has done rather it's where they are headed.
One exercise that I like to perform is coming up with reasonable growth expectations in order to project what kind of returns I can expect. If the returns look good, then it could signify there's value to be had; however, if the returns look poor, then the shares could be overvalued. A quick estimate for future investment returns is the current dividend yield + earnings/dividend growth.
McDonald's is currently yielding 3.30% on a forward looking basis. This is the easiest part of that equation since you're dealing with a relatively known value.
Estimating the growth part of that equation is trickier. One rough guideline is to use the past dividend growth that a company has achieved.
*Image source: Author. Data source: McDonald's Corporation Investor Relations
**An interactive graphical version of this table can be found here.
Despite all the economic booms and busts and various other maladies du jour, McDonald's has consistently given investors raises year after year. Even factoring in some of the leaner years of dividend growth, the "worst" 10-year dividend growth rate works out to 9.13%.
Looking at just the most recent 10 years of data the average dividend growth rates work out as such.
- 1-Year Dividend Growth Rate: 14.38%
- 3-Year Dividend Growth Rate: 17.51%
- 5-Year Dividend Growth Rate: 20.91%
- 10-Year Dividend Growth Rate: 23.25%
I think we'd all rejoice to see McDonald's return to growth like that; however, it's not likely to happen as much of the high dividend growth has been achieved from an expansion of the payout ratio. In 2006, the payout ratio sat at 29.0%, and by the end of 2015, it had climbed to 73.6%. The trailing twelve months shows an improvement with the payout ratio declining to 67.4%; however, that's still over 2.3x higher than a decade ago.
With a stretched payout ratio, investors should temper their expectations for dividend growth compared to the recent past. As such, dividend growth is likely to track or possibly even lag earnings growth in order to build a cushion in the payout ratio.
On a forward looking basis, the average analyst estimate for earnings growth for the next 5 years, according to Yahoo Finance, is 9.34%. Circling back to the return projection equation, the annual return estimate works out to 3.30% + 9.34% = 12.64%.
Valuation Effect on Returns
That's all well and good; however, there is a third part to that equation and that's the change in valuation over time. If the stock market maintained a constant valuation, then investors would see the full value of the growth in earnings over time, although that's rarely the case as markets change their sentiments on companies without any warning.
One of the most common valuation metrics is the P/E ratio. As you can see from the above chart, McDonald's had typically traded hands at a P/E ratio in the 15x-20x range between 2009 and 2015. By the end of 2015, the P/E ratio had ballooned to around 25x and has been trending back down to the 20x range throughout most of this year.
The longer term trend from 2009-2015 had been centered around 17.5x with a high around the 20x level. The problem right now is that the P/E ratio is still on the expensive side. A further reduction in the valuation to the high end of the range suggests that investors could expect to give up an additional 6% of growth over time. A full reversion to the mean around the 17.5 level implies that investors would possibly give up over 18% of future growth due to valuation compression alone.
Putting It All Together
The estimated returns equation is actually dividend yield + earnings/dividend growth + valuation change = estimated annual returns.
Let's take a look at what kind of returns buyers and current owners can expect going forward once we include the effect of valuation shifts. As a reminder, the baseline return estimate, excluding valuation changes, was 12.6%.
First, some assumptions: analysts are expecting 2016 earnings per share of $5.56, 2017 earnings per share of $6.14 and for earnings to grow at 9.3% per year for the following 3 years. To be conservative, I assumed that earnings would then grow at 3% per year from then on.
The annual dividend for 2016 should total $3.61 assuming the 4Q dividend is indeed paid. That gives a payout ratio of 65% for 2016. The dividend is assumed to grow slightly slower than earnings to reduce the payout ratio slightly and will be paid and increased at the same intervals that McDonald's has historically done so.
*Image source: Author. Data Source: Analyst and Author estimates.
I have no idea what future investors will be willing to pay per $1 of McDonald's earnings in the future. Therefore, I like to examine return scenarios at varying future valuations. Returns are calculated as internal rates of return assuming a purchase on 10/17/2016 at the current price of $114.09, collecting all dividends in cash and holding through the end of 2021 and 2026.
If you remember from above the constant valuation, 5-year return estimate was 12.6%. However, once we account for the effects of valuation changes the expected returns look quite different.
Even in the case of reversion to the mean, a future P/E ratio of 17.5x, the internal rates of return looks solid at 9.5% through 2021 and 8.2% through 2026. In a more bearish scenario of a return to the long-term market average of 15x, the returns still look adequate at 6.6% through 2021 and 6.9% through 2026. Considering that's a scenario where you have a 30% total drag on your returns from valuation compression, the returns would still mimic the long-term returns from the market as a whole.
Currently, the valuations for shares of McDonald's appear to be a bit stretched, but not egregiously so. I can't tell you when the valuations will shift; however, the likelihood for lower valuations in the future is much greater than higher valuations barring a massive change in the growth prospects of McDonald's.
McDonald's is unfortunately nearing a saturation of their market and faces strong competition from other fast casual franchises. However, the power of McDonald's business model shines during troubling economic times when consumers downshift to cheaper options.
One big caveat with this analysis is that it uses future growth estimates of earnings per share which is obviously just a best guess. McDonald's could very well grow earnings over 9.3% per year, as analysts expect and as was used in this analysis; however, I wouldn't want to bank on that to support and investment. Especially considering that from 2006 through 2015 earnings only grew at 6.0% per year, although some of that is due to negative currency exchange issues that I expect to subside in the intermediate term.
McDonald's could make for a good investment at these levels IF you believe the growth is likely to play out the same or better than used in the analysis.
For investors looking to add McDonald's to their portfolio, I think the return prospects look good enough for a starter position. Although, obviously the returns would improve with a stricter adherence to valuation.
Due to McDonald's weighting within my portfolio, it's currently over 5% of my portfolio, I see no reason to rush out to purchase shares at these levels and as such would require a better risk/reward ratio. I personally wouldn't make an additional purchase unless the share price declines to $97 or lower. That price point would represent a 17.5x P/E based on 2016's earnings estimates, but would require shares to decline an additional 15% from the current price.
Disclosure: I am/we are long MCD.
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: I am not a financial professional. Please consult an investment advisor and do your own due diligence prior to investing. Investing involves risks. All thoughts/ideas presented in this article are the opinions of the author and should not be taken as investment advice.