Shares of McDonalds (NYSE: MCD) have had a heck of a run over the past three years, much of it down to the performance of the underlying business. I remember some folks writing the fast food giant off back in the 2015 period. Numbers from the company were rather poor – including an alarming 4.1% same store guest count decline in the United States in 2014 – and the stock price hadn’t done much since 2011.
Three years on and both seem to be roaring. The company has now racked up something like thirteen straight quarters of comparable sales growth and is set to earn around $1.5 billion more this year than it did in 2015. Remember all that chatter about how millennials would turn away from unhealthy food like McDonald’s? Well, both systemwide and comparable sales growth are currently positive in each of McDonald’s reporting segments – from the United States to emerging growth markets.
As for the performance of the stock, the share price chart pretty much speaks for itself. Bought the stock at this point in 2015? You saw compound average annual returns of just under 19%. In fact if you look out over the past ten, or even fifteen year horizons, it has been an absolutely phenomenal performer. If you bought McDonald’s shares a decade ago you’d be sitting on average annual returns of over 13%. What about fifteen years ago? 15.5% average annual returns. (N.B. Those figures assume dividends just piled up in a cash account somewhere earning 0%).
That said, there’s a big risk here that becomes apparent when you look at its current valuation. Regular readers will probably know where I’m going with this but bear with me. Check out those fifteen year returns which, as stated above, work out to around 15.5% per annum. Now, that number comprises three different sources. The first is the earnings per share growth that has occurred between 2003 and 2018. In 2003 McDonald’s made around $1.45 per share for its stockholders. This year, analysts think it will earn around $7.75 per share.
Next up we have all that dividend cash paid out over the years. Between this point in 2003 and the present McDonald’s stock has thrown off around $36.50 in cumulative cash dividend payments. Given the share price was around $25.50 back at this point in 2003 you can see it is a pretty significant amount of money. In fact, if McDonald’s stock had gone absolutely nowhere for fifteen years then the dividends alone would still have given you an inflation beating 6% per annum in terms of total average annual return.
The final piece of the jigsaw is the change in valuation the market has placed on McDonald’s stock. At this point fifteen years ago you needed to stump up $17.80 for every $1 of McDonald’s profit. Today, and assuming analysts’ estimates for 2018 earnings per share are somewhat accurate, you need to pay $23.70 for every dollar of net profit.
Imagine for a minute that McDonald’s stock still traded at its mid-December 2003 valuation of 17.8x net earnings. The share price, based on estimated 2018 earnings per share of $7.75, would be around $140. In terms annual returns it would be enough to knock almost two percentage points off our earlier 15.5% per annum figure.
In a nutshell that is why the current valuation is so risky in the short to medium term. What do we suppose the best case scenario is for McDonald’s over the next decade? High single digit earnings per share growth? Most of the gains that should arise from that could be wiped out by valuation movements in the opposite direction. If you think that can’t happen then drag up the long-term stock price. Between 1996 and 2004 the company saw per share earnings increase from $1.08 to $1.93. The share price, on the other hand, went nowhere. Given the stock trades closer to 25x earnings than 20x there’s a risk of history repeating itself, though I continue to think that the business will do just fine.