McDonald's (MCD) - Valuation Analysis

Description

McDonald’s Corporation franchises and operates McDonald’s restaurants in the global restaurant industry. These restaurants serve a varied, limited, value-priced menu in more than 100 countries around the world. All restaurants are operated either by it or by franchisees, including conventional franchisees under franchise arrangements, and foreign affiliated markets and developmental licensees under license agreements. The Company and its franchisees purchase food, packaging, equipment and other goods from various independent suppliers. It offers a range of products. Independently owned and operated distribution centers, approved by it, distribute products and supplies to McDonald’s restaurants. s menu includes hamburgers and cheeseburgers, Big Mac, Quarter Pounder with Cheese, Filet-O-Fish, several chicken sandwiches, Chicken McNuggets, Chicken Selects, Snack Wraps, french fries, salads, shakes, McFlurry desserts, sundaes, soft serve cones, pies and cookies.

Source: Reuters

Valuation

Key assumptions included:

                Terminal growth rate: 3.0%

                Risk-adjusted discount rate: 9.6%

                Cost of sales: 60.0%

                Selling, general, & administrative costs as % of sales: 10.0%

                CAPEX as % of sales: 9.0%

                Depreciation as % of sales: 5.3%

                Effective tax rate: 28.0%

                Day sales in receivables: 17

                Day sales of inventory: 3

                Days payable outstanding: 24

At a 10% growth rate (bull case), I estimate the intrinsic value of MCD to be $75.66 per share.  With a risk-adjusted margin of safety of 11.2%, the target purchase price is $67.15 per share.  This is below the $86.28 per share MCD is currently trading at.  At $86.28, MCD is trading at 14.0% above the intrinsic value indicating it is may be overvalued.

At a 5% growth rate (bear case), I estimate the intrinsic value of MCD to be $59.99 per share.  With a risk-adjusted margin of safety of 14.4%, the target purchase price is $51.33 per share.  This is below the $86.28 per share MCD is currently trading at.  At $86.28, MCD is trading at 43.8% above the intrinsic value indicating it may be overvalued in this scenario. 

Dividends

MCD has paid a quarterly dividend since 2008.  Before that, MCD paid an annual dividend.  From 2001 to 2010, MCD’s total annual dividend has grown from $0.23 per share to $2.26.  The dividend appears to be grow faster than forecasted growth.  The compound annual dividend growth rate is as follows:

                Ten years: 29.9%

Five years: 35.5%

                Three years: 14.6%

Although the dividend is growing faster than net earnings, the dividend appears to be sustainable.  Based on net income, the dividend payout ratio has exceeded 50% once in the past five years.  A dividend payout ratio of less than 50% is a positive allowing for sustainable growth and a cushion for short-term earnings volatility.  From 2006 to 2010, the dividend payout ratio based on net income has grown from 34.3% to 48.7%.  Below is the dividend payout ratio for the past five years:

                2006: 34.3%

                2007: 73.7%

                2008: 42.3%

                2009: 49.1%

                2010: 48.7%

In the book, The Ultimate Dividend Playbook, Josh Peters discusses a model to calculate a stock’s prospective return.  The model is called the Dividend Drill Return Model (DDRM).  It is based on the premise that the dividend total return is equal to the yield plus dividend growth.  Dividend growth is then broken into core growth (the rate of growth for total profits) plus share change (reduction of shares due to share repurchase). 

Given a core growth rate of 10.0% and current dividend yield of 2.8%, MCD’s cost of growth is $1.37 per share.  After reducing this amount and dividends of $2.44 per share from earnings per share, the funding surplus is $0.83; this amount is forecasted to have a 1.0% impact on share price.  As a result, the DDRM forecasts the projected total return for MCD to be 13.8%.  Below is a breakdown of the total return:

                Core growth rate: 10.0%

                Dividend yield: 2.8%

                Funding surplus: 1.0%

                Total return: 13.8%

Summary

In a bull case, based on a valuation $75.66, shares are trading at a 14.0% premium to their intrinsic value.  In a bear case, base on a valuation of $59.99, shares are trading a 43.8% premium to their intrinsic value.  MCD has a history of dividend increases, whether annual or quarterly.  The dividend appears sustainable as the payout ratio is less than 50%.  Based on the DDRM, the projected total return for MCD is 13.8%.

Disclosure: I am not long MCD.