McDonald’s: The Valuation Is Risky

by The Compound Investor

McDonald’s stock (MCD) has had a great run over the past three years, much of it down to the performance of the underlying business. I remember some folks dismissing the fast food giant’s prospects 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 later and both seem to be roaring. The company has now racked up something like thirteen straight quarters of comparable sales growth, and it is set to earn around $1.5b 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.

As for the performance of the stock, the share price chart 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 then you would be sitting on average annual returns of over 13%. What about fifteen years ago? 15.5% average annual returns. Note those figures assume dividends just piled up in a cash account somewhere earning 0%. The true total return is even better.

Valuation

That said, there is a big risk here that becomes apparent when you look at its current valuation. Regular readers will 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 profit growth that has occurred between 2003 and 2018. In 2003, McDonald’s made around $1.45 per share for its stockholders. Analysts think it will earn around $7.75 per share this year.

Next up we have all that dividend cash paid out over the years. McDonald’s stock has thrown off around $36.50 in cumulative cash dividend payments over the past fifteen years. Given the share price was around $25.50 at this point back 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 dividends alone would have given you 6% per annum returns. Not bad.

The final piece of the jigsaw is the change in valuation that the market has placed on McDonald’s stock. Fifteen years ago the stock traded on a PE of circa 18. Today, and assuming analysts’ estimates for 2018 earnings per share are somewhat accurate, the PE stands near 24. Imagine for a minute that McDonald’s stock still traded at its mid-December 2003 PE of 17.8. The share price would be around $140 based on estimated 2018 EPS of $7.75. That, in turn, would be enough to knock almost two percentage points off our earlier 15.5% per annum total return figure.

That is basically 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 EPS 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, drag up the long-term stock price chart. The share price went nowhere between 1996 and 2004, and that came despite EPS increasing from $1.08 to $1.93. There is a risk of history repeating itself, though I continue to think that the business will do just fine.

Note

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