McDonald’s Dividend Stock Analysis
Sometimes I wonder what has happened to my personal values. I invest in and write about:
- Tobacco companies
- Defense contractors
- And now purveyors of fast food
Oh. Now I remember. My values are placed squarely in my wallet. At least as it relates to investing.
I’m just not socially conscious about my investing dollars. As long as they are going to legal businesses, I just follow the dividends.
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The Company franchises and operates McDonald’s restaurants in the food industry.
McDonald’s was founded in 1940 and has become the world’s largest restaurant chain based on revenues.
If you like a little nostalgia, check out the company’s history on its website. It is pretty interesting. Kind of a slice of America. As it came of age over the decades.
The McDonald’s brand is global.
However, the majority of the restaurants are owned and operated by 5,000 small and mid-sized businessmen and women. These business owners are known as franchisees.
In fact, more than 80% of restaurants worldwide are locally-owned franchises. And the count is even higher in the United States at more than 90%.
Source: McDonald’s Business Model
I like the simplicity of McDonald’s growth strategy. Simply put, they want to grow by serving more customers, more often. And by providing those customers good value for their money.
McDonalds’ seeks to:
- Retain the customers they have
- Regain the customers they have lost
- Convert casual customers to frequent committed customers
Underlying these growth initiatives is a focus on:
- Digital interactions with their customer base
- Delivery of food and beverages to home, offices and other community locations
- Elevating the restaurant experience through people and technology
Source: McDonald’s Growth Strategy
McDonald’s Dividend Yield
McDonald’s pays an annual forward dividend of $4.64 per share. As a result, this is a 2.1% McDonald’s dividend yield at the recent stock price.
McDonald’s Dividend Growth Rate
|1 Year||3 Years||5 Years||7 Years|
Dividend growth has been steady and consistent for the last 7 years.
Most noteworthy, the McDonald’s dividend was increased a whopping 14.9% in 2018. This represents a clear break to the upside from the past trend.
Also, McDonald’s has raised its dividend each year since paying its first dividend in 1976. That is a very long dividend increase streak of 43 years!
Source: McDonald’s Dividend History
McDonald’s Revenue Trend
Revenue has been on the decline for a number of years.
More Franchised Restaurants
Revenue declines have primarily been due to the company’s re-franchising efforts.
Because, over the past few years, McDonald’s has intentionally shifted to a greater percentage of franchised restaurants. Rather than company-owned restaurants.
This shift negatively impacts revenues as Company-operated restaurant sales are replaced by franchised sales.
As a franchiser, McDonald’s receives rent and royalty revenue. Rather than revenue from the sale of food and beverages.
The Advantage Of Franchised Restaurants
The advantage of this strategy is higher profit margins. And, less need for capital expenditures to build new, and remodel old restaurants.
As a result, the company’s gross profit margin dollars have remained stable during this period of declining revenue.
Gross profit as a percentage of sales has increased nicely. And that is a positive financial indicator.
McDonald’s Dividend, Earnings, And Payout Ratio
McDonald’s earnings per share have grown rapidly over the last several years. This is a result of
- Reductions in selling, general and administrative expenses
- Gains realized on the sale of company-owned restaurants as part of the re-franchising effort
- Fewer shares of stock outstanding as a result of company share buybacks
The dividend payout ratio is running at 60% of earnings. This is a comfortable level, but let’s check it against free cash flow.
McDonald’s Dividend & Free Cash Flow
In 2018, the dividend consumed 77% of free cash flow. This is an acceptable level for a large mature company like McDonald’s.
However, I would not expect management to let the dividend payout ratio increase much in the years to come.
A lower dividend payout ratio is generally better. It shows the company has ample room to raise the dividend in the coming years. Or, withstand an earnings drop without having to reduce the dividend.
McDonald’s Dividend Growth Forecast
Management expects annual earnings per share growth in the high single-digit percentages. And I would expect future dividend growth to be about the same. Perhaps even a little less to reduce the payout ratio.
I’m forecasting future dividend growth in the 5-7% range for my planning purposes.
McDonald’s Financial Position
A company’s financial position is important to understand. So let’s look a that now.
A company’s credit rating can make a big difference between companies that struggle. And those who thrive during difficult times.
A corporation’s credit rating is similar to how your personal credit score works.
Specifically, higher ratings mean lower risk to those who lend the company money. Also, higher ratings mean lenders will likely get their money paid back when it is due.
McDonald’s has BBB+ and Baa1 investment grade-moderate credit risk ratings.
These ratings are provided by two of the big rating agencies: Moody’s and S&P.
They are adequate. But, at the lower end of the investment-grade spectrum as shown in the chart above.
Most companies with high-quality dividend stocks have an investment-grade credit rating. And McDonald’s is no exception.
Debt Levels Have Been On The Rise
Lower credit ratings for McDonald’s are likely due to the large debt levels carried by the company. In recent years, McDonald’s has taken on debt to fund the combination of large dividend payments and share repurchases.
Returning large amounts of cash to shareholders in the form of dividends and share repurchases is a great practice by management. But, borrowing money to do so can be risky.
The debt levels and credit ratings should be watched closely moving forward. And they are another reason, in my opinion, dividend growth will be constrained in future years.
McDonald’s Stock Valuation
McDonald’s stock price has risen dramatically over the past decade.
In fact, it has nearly quadrupled in value. My guess is that McDonald’s stock is overvalued, but let’s prove that out.
I will use the following valuation measures:
- Single-stage dividend discount model
- Morningstar fair value estimate
- Price to earnings ratio
- Dividend yield
McDonald’s Dividend Discount Model
The single-stage dividend discount model considers several factors I have discussed thus far:
- Current annual dividend payment – $4.64
- Projected dividend growth – 6%
- My desired annual return on investment – 9%
Based on these assumptions, the dividend discount model calculates the fair value of McDonald’s stock at $164 per share.
Morningstar Fair Value
The investment analysis firm, Morningstar, believes McDonald’s stock is fairly valued at $215 dollars per share. Source: Morningstar
McDonald’s Stock Price To Earnings Ratio
The McDonald’s stock price to 2019 earnings is 28 times. In comparison, the S&P 500 is valued at 18 times 2019 earnings.
It is not uncommon for high-quality dividend growth stocks to be valued more highly than the overall stock market. But McDonald’s stock value looks excessive to me. Especially given its modest growth prospects.
Remember that in most cases, a lower price to earnings ratio typically represents a better value for the investor.
I would be more comfortable buying McDonalds’ shares at 20 times 2019 earnings. So a McDonald’s stock price of $154 per share would leave it trading at 20 times earnings. This is a more reasonable valuation to me.
McDonald’s Dividend Yield
As regular readers know, I prefer to buy dividend stocks with yields in the 3-5% range. And McDonald’s dividend yield is just a little over 2%.
I personally would prefer to buy more McDonald’s stock at a minimum 3% dividend yield. A 3% dividend yield would give us a McDonald’s stock price of $155 per share.
McDonald’s Stock Valuation Summary
We have looked at a number of valuation methods. All of them suggest McDonald’s stock is overvalued.
Here is a summary:
- Dividend discount model – $164 per share
- Morningstar fair value $215 per share
- Price to earnings ratio to 20 times – $154
- 3% dividend yield – $141 per share
McDonald’s Dividend Stock Analysis Summary
The company has migrated to more franchised owned stores. This business model has reduced the need for capital expenditures and increased profit margins.
McDonald’s stock has performed very well over the past decade.
However, the low dividend yield and projected 5-7% dividend growth is not an overly attractive combination for me as a dividend growth stock investor.
McDonald’s holds a mid-sized position in my dividend stock portfolio. I intend to hold for the long term, but I won’t be a buyer at these prices.
Absent changes in the fundamentals, it will take a significant correction in the stock price to make me an interested buyer.
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