This is a guest contribution from Ben Reynolds at Sure Dividend. Sure Dividend simplifies the process of dividend growth investing with The 8 Rules of Dividend Investing.
In August of 2015 McDonald’s (MCD) stock traded for a low of $85/share. The company is now trading for around $128/share.
McDonald’s stock is up around 50% since its August lows. Has the company’s recent stock price moves made the company a stronger buy, or should you sell McDonald’s now to lock in gains?
McDonald’s Competitive Advantage
McDonald’s has paid increasing dividends for 39 consecutive years. The company’s long dividend streak makes McDonald’s a Dividend Aristocrat. There are currently only 50 Dividend Aristocrats – stocks with 25+ years of consecutive dividend increases.
The company’s long dividend streak speaks to its strong competitive advantage. A business simply cannot pay increasing dividends for so long without having a strong competitive advantage.
McDonald’s competitive advantage comes primarily from three factors:
- Well-known brand
- Industry leading size and scale
- Capital efficient franchise business model
The golden arches are recognized globally. McDonald’s continues to build its brand with sizeable advertising expenditures. McDonald’s regularly spends around $900 million a year on advertising.
McDonald’s is much larger than its competition. This give the company a size and scale advantage. McDonald’s has a market cap of $116 billion. The 2nd largest restaurant in the world – Yum! Brands (YUM) – has a market cap of $36 billion.
The company’s massive size relative to its peers allows it to buy commodity food products from suppliers at the lowest possible price. McDonald’s has historically offered extremely affordable “value menu” and “dollar menu” offerings.
McDonald’s has more than 35,000 locations in over 100 countries. In Europe, North America, and increasingly Asia, McDonald’s is very easy to find.
The franchise business model allows McDonald’s to grow quickly. Only about 20% of McDonald’s locations are company operated. The remaining 80% are operated by entrepreneurs who pay to use the McDonald name and products. Franchising minimizes the cost of opening a store for McDonald’s and spreads risk to the franchise owner rather than McDonald’s corporation. It results in a highly capital efficient business that is easy to scale.
McDonald’s is an excellent business… But is it priced to buy?
McDonald’s average price-to-earnings ratio since 2000 is 16.1. The company is currently trading for a price-to-earnings ratio of 26.6.
McDonald’s stock would have to fall by around 40% to reach its historical average price-to-earnings range.
Of course this doesn’t mean the company’s share price is about to fall 40% – that is very unlikely.
For a company to trade far above its historical average price-to-earnings ratio it must have better growth prospects than it did in the past.
This does not appear to be the case with McDonald’s over the long run. With that said, short-term results have been very impressive. Relevant financial information from the company’s latest quarter is shown below:
- Comparable store sales up 5.0%
- Earnings-per-share growth of 16.0%
- Constant-currency earnings-per-share growth of 26.0%
These are the type of numbers that do command a premium price-to-earnings multiple. Growth at this rapid rate will not persist over the long-run for McDonald’s.
McDonald’s has compounded its earnings-per-share at 8.5% a year over the last 15 years. This is a very respectable growth rate – especially considering the company paid out around 50% of its earnings as dividends over this period.
If McDonald’s continues to grow at 8.5% a year and continues to pay its dividend (current yield of 2.8%) shareholders can expect total returns of around 11.3% a year going forward.
This is greater than the S&P 500’s long-term historical average return of around 9% a year. An argument could be made that McDonald’s commands a price-to-earnings ratio greater than the S&P 500.
The historical average price-to-earnings ratio of the S&P 500 is 15.6. It is currently at 22.6. The stock market needs to fall by about 31% to fall in line with its historical price-to-earnings average.
Based on these numbers it appears that McDonald’s is not terribly overvalued. It is trading at a premium to the S&P 500 – but that should be expected for an excellent business.
McDonald’s: Buy, Hold, or Sell?
But just because a business is not extremely overvalued does not make it a buy.
While McDonald’s isn’t excessively overvalued, it is very likely trading above fair value. I would put the company’s stock into the ‘somewhat overvalued’ category.
Intelligent investors wait to purchase high quality businesses until they trade at fair or better prices. Here’s a quote from Warren Buffett on the matter:
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
McDonald’s may sell inexpensive burgers, but the price of its stock is anything but marked down.
I am currently long McDonald’s. While the company is a bit overvalued, I don’t believe it is a sell at current prices either. The company will very likely continue growing per-share value through:
- Share repurchases
- Comparable store sales growth
- Continued store expansion internationally
This growth will bring about continued dividend increases. I don’t want to ‘cash out’ the dividend income my McDonald’s investment brings.
Selling the company’s stock now would incur capital gains taxes (in taxable accounts). Investors should deduct this lost tax money from any investment they make with funds from a sale. Allowing money that would be paid out in taxes to compound is one of the advantages of long-term investing.
McDonald’s is not so absurdly overvalued that it should be sold. For investors who currently own McDonald’s, the stock is a hold.
In summary, McDonald’s is:
- A hold at current prices
- Probably somewhat overvalued
- Will very likely continue growing its dividend far into the future
Dividend Monk’s Note:
Back in April of 2015, I’ve reviewed MCD with a similar approach. I determined the fair market value at $98 considering a 5.5% dividend growth rate. If I adjust the numbers today and consider a 5% dividend growth rate for the first 10 years and then 6% for the years after, I get a higher value, but still, MCD is overvalued:
|Input Descriptions for 15-Cell Matrix||INPUTS|
|Enter Recent Annual Dividend Payment:||$3.56|
|Enter Expected Dividend Growth Rate Years 1-10:||5.00%|
|Enter Expected Terminal Dividend Growth Rate:||6.00%|
|Enter Discount Rate:||9.00%|
|Calculated Intrinsic Value OUTPUT 15-Cell Matrix|
|Discount Rate (Horizontal)|
|Margin of Safety||8.00%||9.00%||10.00%|