McDonald’s Corporation (NYSE:MCD) is one of the finest businesses around. However, I have been concerned for some time that the stock is too expensive at the current price, and a high rate of earnings growth would be needed to justify entry at the current price of $157.
(Source: Investing.com)
Looking forward, does McDonald’s have the capacity to rise further, and does the company have the earnings growth to back it up?
In its most recent earnings report, a stronger-than-expected first quarter had significantly increased sales and earnings. What is particularly impressive about the company is that while menu prices had risen, this had not affected demand, and overall revenue grew as a result.
Moreover, with earnings per share having risen by 17% from $1.47 to $1.72 in Q1, this significantly exceeded the 10% earnings growth target that I had predicted previously.
Back in April, I devised a dividend discount model to forecast a five-year target price for McDonald’s.
My assumptions were as follows:
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The discount rate was assumed to be 7%, in line with the assumed long-term rate of return on the S&P 500.
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Earnings growth per year was assumed to be 10%.
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Dividend growth per year was assumed to be 5%.
| Dividend Per Share Forecast (Year 1 to 5) | |||||
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Projected 5% dividend growth | 1.01 | 1.06 | 1.11 | 1.17 | 1.23 |
| 7% discount rate | 0.96 | 0.93 | 0.91 | 0.89 | 0.88 |
| Earnings Per Share Forecast (Year 1 to 5) | |||||
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Projected 10% earnings growth | 5.59 | 6.15 | 6.76 | 7.44 | 8.18 |
| 7% discount rate | 2.71 | 5.37 | 5.52 | 5.68 | 5.84 |
| Terminal P/E Ratio | 24.46 |
| Terminal P/E * Estimated EPS in Year 5 | 142.73 |
| Present Value of Dividends Per Share Through To Year 5 | 4.56 |
| Target Price in Year 5 | 147.29 |
| Upside from price of $157.21 | -6.31% |
| 5-Year Annualized Rate of Return | -1.26% |
(Source: Author’s calculations)
We see that with a target price of $147, this yields a downside of -6.31%.
Looking forward to Q2 earnings, analysts are expecting a consensus earnings per share of $1.93, which would represent a 12% upside from the previous quarter. While earnings estimates are expected to moderate somewhat after this, McDonald’s has seen positive earnings surprises for the past four quarters, and for this reason, I am optimistic on further earnings growth from here.
Using a growth rate of 15%, I now wish to amend the earnings forecast in the original DDM model to see what would happen to the target price:
| Dividend Per Share Forecast (Year 1 to 5) | |||||
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Projected 5% dividend growth | 1.01 | 1.06 | 1.11 | 1.17 | 1.23 |
| 7% discount rate | 0.96 | 0.93 | 0.91 | 0.89 | 0.88 |
| Earnings Per Share Forecast (Year 1 to 5) | |||||
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Projected 15% earnings growth | 5.59 | 6.43 | 7.39 | 8.50 | 9.78 |
| 7% discount rate | 2.71 | 5.61 | 6.03 | 6.49 | 6.97 |
| Terminal P/E Ratio | 24.46 |
| Terminal P/E * Estimated EPS in Year 5 | 170.51 |
| Present Value of Dividends Per Share Through To Year 5 | 4.56 |
| Target Price in Year 5 | 175.07 |
| Upside from price of $157.21 | 11.36% |
| 5-Year Annualized Rate of Return | 2.27% |
(Source: Author’s calculations)
Assuming 15% growth in earnings per year for the next five years, we foresee just under a 12% upside, or 2.27% average return per year over the next five years.
Based on the above, the stock would still not offer a significantly high rate of return to justify going long at this point.
Average earnings growth per year would need to be at least 20% to yield a 31% return, or an average of 6.2% per year. Assuming 15% earnings growth instead, investors would need to see a price of $130 for a 34.67% upside, or nearly 7% annually.
That said, McDonald’s did recently see highs of above $170 not too long ago, and therefore, while this stock might be attractive from a more short-term swing trading view, i.e., picking the tops and the bottoms, McDonald’s would need to show more earnings growth to ultimately sustain a price above the $170 level.
In the previous quarter, much of the reason for the 17% earnings growth was an increase in revenues primarily resulting from higher menu prices. Revenue growth was particularly impressive in the U.S. and China, which is encouraging. Revenues from franchised restaurants were up by 15% – while sales by company-owned restaurants did technically lead to a revenue decline of 9%, this did not materially affect earnings.
Looking forward, should McDonald’s continue to increase sales from franchised restaurants while gradually winding down costs incurred by sales of company-owned restaurants, it is quite possible that it could sustain current earnings growth rates.
Earnings on July 26 will be a significant telling point as to whether McDonald’s is set to see above 15% earnings growth this year. Should the company significantly beat expectations, this could be a positive sign, since it indicates the ability of McDonald’s to further increase its franchise sales while concurrently lowering expenses of company-operated restaurants, in which case we can expect earnings growth to be more aggressive going forward. In addition to earnings, I will be watching for these two metrics in particular.
To conclude, McDonald’s is a stock that is starting to show good earnings growth, and the company has a strong business overall. That said, the company would need to see yearly earnings growth of at least 15% (closer to 20% is preferable) for the stock to have significant upside at this price. July 26 will be a good indication as to whether it is on track to achieve this.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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