Above is a 5-year weekly chart for McDonald’s (MCD). As described by David Gordon of The Deipnosophist, MCD seems to have entered a hesitation after a strong, multi-year bull run. Over the last year, however, a symmetrical triangle seems to have formed which is a type of intermediate term base which is expected to end in a breakout or breakdown, though usually symmetrical triangles signal a brief pause before the continuation of the primary trend. But, I’ll leave the discussion of technical analysis for another post. If you’re interested in an extensive analysis of MCD’s chart patterns do follow the above link to David’s post.
While this technical strength as well as McDonald’s 3.7% dividend are tempting to me, I am typically reticent to invest in a stock which has had such a profound bullish move in just the last few years. Truth is, however, McDonald’s reached its current valuation levels in 2007 and it would seem that the stock’s nearly two year long hesistation may have given more than enough time for earnings and cash flow to come in line with market perception. Let’s take a deeper look.
On a relative basis, McDonald’s seems to trade roughly in line with peers on a price to earnings basis. Admittedly, this is not a very large sample size, but it does represent the market’s most comparable competitors. As a franchiser which does not rely on its own assets to generate cash flow, I would expect most of these types of businesses to trade at a premium to book value and, as a result, I focus more on the P/E numbers. Generally speaking, I believe a mature business with stable earnings like McDonald’s should earn a baseline P/E of 10x. 10x earnings would generall be equivalent to the Company’s no-growth earnings power value at a standard discount rate of 10%. As such, McDonald’s seems to be trading at a slight premium to this which implies that there market is pricing in a modest growth premium.
Above, I’m using my “patented” 5-year to Maturity DCF Model. The growth rates row contains the annualized growth rate for the first five years of the model. After five years, the model assumes that the business will “mature” and become a standard 2.5% growth per year type of business. The total value of the DCF is then divided by current shares outstanding to give a valuation table in $/share. MCD is currently priced at $54.23/share. The baseline free cash flows that the model grows off of are trailing twelve months operating cash minus capital expenditures.
What we see is that McDonald’s is trading at levels implying essentially no growth when assuming an 8% discount rate. At a more normal 10% discount rate, MCD’s current price implies annual growth in excess of 8.0%/year. Is this reasonable? McDonald’s has significant international exposure with over 60% of revenues coming from overseas. As such, realistic long term growth rates are likely in the neighborhood of 4% as opposed to 2.5% and near term (5 years-ish) growth is likely easily in the 5-6% range if not better. In fact, over the last five years, McDonald’s has grown its rolling average five-year free cash flows* at a 10% CAGR.
All told, it would seem that McDonald’s while not trading at an extreme value, does offer relatively fair value while also paying a significant dividend and exhibiting technical strength. It would seem that this is a stock worth holding, or possibly even accumulating on weakness as its symmetrical triangle continues to form in anticipation of an upside breakout and continuation of the primary trend. Should the pattern break down, however, I would put in as stop-loss at $50/share and then look to reacquire shares at a true value price below $45/share, preferably closer to $40/share.
* Rolling average five year free cash flows are defined as, for year n, the average of the year n cash flows and the previous four years’ free cash flows.
Full Disclosure: Author is long shares of MCD at the time of writing. No positions in other stocks mentioned in this article.