McDonald's Is Starting To Look Interesting Again

| About: McDonald's Corporation (MCD)
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Shares of McDonald’s traded over $130 earlier this year.

Since that time the share price has declined materially.

This article looks at how much more attractive the investment could be today.

In May of 2016, shares of McDonald's (NYSE:MCD) exchanged hands at a high price of nearly $132. As I write this - now five months later - shares are trading closer to $112. That's a pretty sizable gap (~15%) in such a short amount of time.

The interesting part to me is that I would contend that there haven't been too many changes in expectations during this period. In the short-term sure, there are always reasons to explain a share price wiggle. Yet over the long-term, the basic expectations for a shareholder's underlying earnings claim hasn't been materially altered. Indeed, if anything the anticipations are now better than they were.

I'll show you what I mean. Here's a look at the past three estimates - put out by Value Line - for McDonald's short and intermediate-term business:

Now granted it's not fair to suggest that one analyst speaks for all. Yet the point is that it's not as if the large share price decline is a result of lesser expectations. McDonald's is now anticipated to generate more profits. And the forecast for dividends and a variety of other metrics have stayed the same or improved throughout as well.

Combined, these two factors - a lower price and steady or improved expectations - offer a much more compelling security. Let's work through a demonstration to see how this could shake out in the years to come.

Analysts are presently anticipating rather robust growth for McDonald's over the intermediate-term - approaching 10%. During the past couple of decades McDonald's has traded with an average earnings multiple in the 18 to 20 range. Using these two numbers we can start to look at some scenarios for the security:

Naturally these numbers ought to be adjusted according to your own expectations, but the idea is to come up with a range of scenarios and compare this to the previous price.

I presented four cases: "bull," "base," "slow" and "zero." Each highlights varying earnings-per-share and dividend growth rates ranging from 0% to 10% for the next five years. Dividends are anticipated to grow in line with earnings, which appears to be a sensible baseline given the company's payout ratio.

The ending P/E ratio has a large influence on your future returns. If you believe McDonald's can grow in the 6% to 10% range and shares ought to trade with a high teens or low-20's multiple, the potential annual return looks reasonably interesting. This is especially true when you consider the 3.3% starting yield.

Alternatively, if you suspect that the business will not grow as fast, your potential returns are rather unimpressive. McDonald's has often traded with a "premium" valuation, but should this or growth falter, even today's reduced price may not look attractive. It all comes down to your expectations about the business and from there you can figure out whether or not shares are offering a "fair shake."

In any event, the potential returns at $112 are apt to be materially better than the returns at $132 (given similar or improved assumptions). Here's a look at the potential returns over a five-year period with a starting share price at $112 versus $132:

You can see that shares of McDonald's are potentially much more attractive at $112 instead of $132. Naturally this is obvious - I just changed the share price, not the scenarios - but it can still be helpful to quantify the difference.

As a point of reference, using the "base" case, a 7.9% annual gain would turn a $10,000 starting investment into about $14,600 after five years. That same $10,000 investment growing at 4.4% per annum would be worth roughly $12,400 - nearly half the gain (~$2,200 less). In this context you can see that a few percent difference per year can really add up quite quickly.

In short, in my view shares of McDonald's are now more attractive today as compared to five months ago. And the reasoning is simple: the intermediate-term expectations for the business are the same or even a bit better, and yet the share price is now down materially.

Before you had to presume that McDonald's would grow at or near a double-digit pace and continue to trade around 20 times earnings to justify an investment thesis. Those things are possible, but the higher price created a higher "investment bar" as well.

Today you can have slightly subdued expectations - say 6% growth and a bit lower multiple - and still see solid gains. In other words, the "investment bar" is now lower. This doesn't mean that an investment has to work out, but continuing or prospective shareholders ought to be more interested today as compared to a few months ago.

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.