McDonald’s stock analysis: there is even more to come?

McDonald’s stock is considered a lucrative dividend investment and very popular amongst investors. The stock price has been rising for decades(!) and has literally skyrocketed in recent years. Between 2015 and 2019 the price has even more than doubled. This is due to a change in McDonald’s business strategy, which has enabled the company to increase its profitability enormously. This strategy was very well received by the stock market. How McDonald’s managed this miracle and whether you as an investor can also benefit from it, you find out in this analysis.

McDonald’s Stock
Logo
Country	USA
Industry	Restaurants
Isin	US5801351017
Market Cap.	138,4 billion USD
Dividend Yield	2,6%
Dividend Stability	1.0 (max. 1.0)
Earnings Stability	0.97 (max. 1.0)

The business model: How McDonald’s earns (even more) money

The original business model of McDonald’s should be familiar to almost everyone. Founded in 1940 as a burger stand, the business soon turned into the prototype of the franchise we know today. The restaurants have expanded rapidly and can now be found in almost every country around the globe. Today, there are 38,000 restaurants serving almost 70 million customers every day. This makes McDonald’s the second largest restaurant chain in terms of the number of branches worldwide. Only Subway has even more locations with 42,000 branches.

McDonald’s restaurant

McDonald’s earns money operating their own restaurants and with royalty payments from franchisees. Almost everyone knows that McDonald’s is a franchise. However, until recently, a good percentage of the restaurants were owned by the company it-self. That has changed a lot in recent years. In 2015, McDonald’s presented a plan for a new strategy. At that time about 80 percent of the restaurants were owned by franchisees. The new strategy was to eventually increase this percentage to 95 percent. This objective is nearly reached. By the end of 2019, 93 percent of McDonald’s restaurants were licensed out to franchisees. This strategy has increased the profitability of McDonald’s enormously and is probably one of the main reasons for the rapid rise of the stock price. In the chart below you  see how the stock price rose during the period of the strategy implementation.

Price chart of McDonald’s stock (source: Tradingview.com)

Why McDonald’s is so profitable

For decades McDonald’s has been increasing its earnings per share without major setbacks. In the chart you can see the smooth increase in profits and cash flow per share. You can also see the development of the dividend, which has been increased every year without exception. Another plus is the fact that the dividend has always been financed sustainably from the increase in profits.

Development of profits and cash flows per share of McDonald’s

McDonald’s was already a very profitable company before the implementation of the new business strategy. Thanks to the restaurants’ standardized menus, the supply chains are very efficient. Marketing expenses are also very effective. The uniform product range in combination with high volumes also reduces material costs considerably. This in turn ensures high margins. Thanks to the low costs, McDonald’s can still offer its customers products at low prices and at the same time achieve high profits for itself.

If you look at the development of sales, you will certainly notice the negative trend in recent years. This is also an effect of the new strategy. In 2015, McDonald’s started to convert a large part of the remaining restaurants owned by the company into franchises. The loss of sales is due to the fact that the restaurants’ revenues are no longer counted as McDonald’s’ sales. Instead, the company generates its revenues from the royalties that the franchisees pay to McDonald’s. However, this also eliminates the costs of running the restaurants. McDonald’s also has to invest less because it no longer has to maintain the restaurants itself. The strategy has led to a one-time loss of revenue. But McDonald’s has become a much more profitable company. As a result of the strategy, the operating margin has increased from just under 29% in 2015 to over 41% today. The royalties are a stable source of income without McDonald’s having to actively manage the restaurants.

Development of revenues and the operating margin of McDonald’s

Are dividends safe?

Since McDonald’s paid its first dividend in 1976, the amount has been increased every year without exception. Therefore, McDonald’s has not only paid a dividend for 44 years without interruption but has also increased it for 44 consecutive years. In the past 10 years alone, the dividend has more than doubled, representing an annual growth rate of 8.53 percent. McDonald’s has thus more than earned its name as a dividend aristocrat. This is the name given to companies that have continuously increased their dividends for 25 years.

McDonald's Dividend History

As usual in the US, McDonald’s pays its dividend on a quarterly basis. The next payment this year should be in mid-June. Currently, shareholders receive 1.25 dollars. McDonald’s always starts the dividend increases with the last quarterly payment of the year. The increased amount is then also the amount for the first 3 quarters of the following year. It is estimated that McDonald’s shareholders will receive more than 5 dollars for the first time this year. If we assume 1.35 dollars (estimated value) for the last dividend this year, this would result in an amount of 5.10 dollars, which would correspond to a dividend yield of 2.8 percent. This puts the yield in the middle range of most companies. There are other solid dividend payers with a higher yield of 3-4 percent. However, there are also companies like Apple, which only has a dividend yield of 1 percent as a result of its enormous price increase.

The degree of indebtedness is very important for the safety of the dividend. The debt of McDonald’s has risen rapidly in recent years. More precisely, it has doubled in the last 5 years. The main reason for this is share buybacks. Buying back their own shares is a popular instrument for companies to return profits to shareholders in a tax-efficient way. McDonald’s uses this instrument very aggressively. Between 2015 and 2019, the company has used a total of USD 32 billion for share buybacks. If you look at the bottom debt chart and see the increase over this period, you will notice that this is about the same amount as the increase over this period. The rising debt is the bars in red. The value of the shares bought back is shown in yellow.

Development of the debt level and share buybacks of McDonald’s

Perhaps you are now wondering whether share buybacks financed by borrowing are sustainable. These doubts are actually not unjustified. Basically, a company cannot borrow indefinitely to buy back shares. The shareholders would not gain anything by this either, because the money for the buybacks including interest must be paid back at some point. At McDonald’s, the buybacks have a strategic reasoning. The idea is to change equity for debt. This is done because equity is a lot more expensive than debt for companies like McDonald’s. McDonald’s has exchanged expensive equity capital for cheaper borrowed capital piece by piece through its share buybacks. This increases the debt but lowers the cost of capital. Nevertheless, higher debt also means higher risk. However, since McDonald’s generates stable earnings, the risk of problems related to the debt burden is reduced. I therefore do not consider the aggressive buyback of shares to be problematic. This tactic makes sense, especially with the current historically low interest rates. McDonald’s also doesn’t have to worry about not being able to service the interest on the debt. The operating profit in 2019 was more than 7 times the interest burden.

The dividend is therefore not endangered by the debt. The payout ratio also offers no cause for concern. It indicates what proportion of the profit/free cash flow a company has to use for the dividend. For McDonald’s this is currently about two thirds. So theoretically McDonald’s could increase the dividend by increasing the payout ratio. In fact, the payout ratio has increased over the years. But I expect it to stay at the current level of slightly below 70 percent to maintain some flexibility. So, in the future, dividend increases will have to come from profit growth.

In terms of profits, McDonald’s has grown strongly in recent years. Initially sales were lost due to the re-franchising strategy. But profitability has improved considerably. You can see this in the increase in the operating margin. The decline in sales was also a one-time effect. Sales should increase again in the future. And then, because of the higher margins, a lot more of that growth will remain as profit. This means you can continue to expect rising dividends in the future.

Is McDonald’s stock overvalued?

Although the price of McDonald’s stock has risen sharply in recent years, I do not consider the stock to be overvalued. The Dynamic Valuation on DividendStocks.Cash calculates a fair value dividend of USD 206. This is 12% above the current stock price of USD 184. You get this fair value if you start the valuation period in 2017. I chose this period because it reflects the new, more profitable company much better than a longer period that starts earlier. Starting the valuation period earlier would not give McDonald’s credit for the improvements made in recent years.

However, consider that the fair values based on cash flows and profits are closer to the current price. Due to declining profits and cash flows in the current fiscal year, these fair values also have a lower forecast for 2020, but you can also see that the values should recover quickly afterwards. In my opinion, the losses caused by the Corona Pandemic are only temporary. That is why profits and therefore the fair value should rise again in the following years.

Estimating the fair value of McDonald’s stock

Conclusion: McDonald’s stock – there is even more to come

McDonald’s has made considerable improvements in recent years. The re-franchising strategy has been a complete success. The secure, regular royalty income and lower costs will enable McDonald’s to increase its dividend in the future. The sharp rise in the share price is justified because McDonald’s is a much better company today than it was 5 years ago. Despite the price increase, I do not consider the stock to be too expensive, considering the quality of the company. If you are still waiting for a price reduction, you can set a price limit on Dividendstocks.cash to catch the knife before it will rebounce once again to jump even higher.