- McDonald's stock is expensive with its earnings multiple (Price to Earnings ratio) well over historic averages.
- However, the market is bullish on McDonald's prospects with last year's EPS growth of 15%+ and projected growth of 12%+ in 2016.
- McDonald's is only suited for long-term investors right now.
McDonalds (NYSE:MCD) is currently trading at just under $119 a share and is approaching its all-time highs. McDonald's third-quarter earnings in 2015 were the catalyst for the stock breaking out of its trading range of around $100 a share - which it had held since the start of 2012 (see graph below). In fact, the share price didn't move between 2012 and September 2015 despite the revenue and earnings decline since 2013. Nevertheless, the company's third quarter earnings in 2015 were the catalyst, because the decline in same-store sales in the US (7 straight quarters) finally came to an abrupt halt. The US market is crucial to McDonald's as it contributes around 40% of top line sales and over 50% of operating profits.
Therefore, when the market saw the turnaround in sales in the US, it valued the stock differently. Fourth quarter earnings announced in late January continued the momentum garnered in Q3. McDonald's announced a beat both on the top and bottom lines and growth in the US definitely seems to be back in earnest especially as the restaurant chain now has the tailwind of a booming All Day Breakfast offering. Same-store sales in the US actually spiked by 5.7% which was well above the consensus estimate of 3.2%. As a result of the turnaround in the US over the past 2 quarters combined with growth in its international and high growth markets, momentum has driven the McDonald's earnings multiple (Price to Earnings ratio) to 24.65 which is well above the company's 5 and 10 year averages. I am not saying that you shouldn't invest in McDonald's at this time, but before you invest, you should start with the end goal in mind. Let's go through a few examples so you can choose for yourself whether this is the right investment for you at this moment in time.
Firstly, investors should be aware that the company is getting smaller in the sense that revenue projections in 2016 and 2017 are much smaller than sales reported in 2013 for example. The management wants to make McDonald's much more streamlined so that earnings per share and free cash flow metrics become the priorities going forward. The company wants to achieve this by focused cost cutting ($500 million in SG&A reductions through 2018), re-franchising (4,000 outlets by the end of 2018) and a more streamlined menu which should mean quicker service over time.
Therefore, for long-term investors (10 - 15 years+), it's hard to go wrong with an investment in McDonald's. Why? Well, despite having a high valuation at the moment (which won't last in my opinion), dividends re-invested at different times will ensure dollar cost averaging can occur over time which basically means that investors will be buying stock invariably at different prices. For example, at the end of 2007, the stock was trading at over $61 a share and had reported earnings per share for that year of $1.98. If you divide the two numbers, you get an earnings multiple of over 30 which again is way over its historical average of around 19. What would have happened if you invested in this stock at the end of 2007? Well, in hindsight, the great recession helped the company's EPS enormously over 2008 and 2009 which brought down its earnings multiple significantly. So you would have ended up buying at various earnings multiples, averaging out.
The stock's performance in the great recession shouldn't be underestimated by investors (as history could repeat) as McDonald's seems to thrive in periods of economic contraction. In fact, a $20,000 investment at the end of 2007 would have turned into $51,236 (12.2% annualized return) by March 2016 (assuming all 33 dividend payments were reinvested) despite starting out with a high earnings multiple. What's the takeaway of our first example? Well, over the long term, investors should do very well in a company like McDonald's if one re-invests the increasing dividend every year so that compounding and dollar cost averaging can occur over time.
However, what if the investor wanted short term gain or short term income? ( span of 2 to 3 years). In this case, the investment becomes a different ball game for a number of reasons. Firstly, because of the low EPS in 2007, the dividend payout ratio had spiked to 78% which meant future buybacks and dividend growth were always going to be lower than previous years. However here is the real kicker. Earnings per share actually more than doubled between 2007 and 2009, but the share price hardly moved. This is crucial for investors. Just because a company reports substantial earnings growth, it doesn't mean that the share price will reflect that growth. An investment of $20,000 at the end of 2007 (assuming all dividends were reinvested) would have turned into $22,359 returning a meager annualized return of 5.69%.
This brings me to the present (March 2016), which has some similarities with 2007. The company's expected EPS growth rate is over 12% for 2016 and almost 10% annualized over the next 5 years. However, investors should look at what has happened to earnings and the share price in the previous five years to get a gauge of where the share price is headed going forward. Over the last 5 years, the stock has rallied almost 60% but earnings didn't even grown by 1% on an annualized basis. This leads me to believe that even if McDonald's comes good with its future earnings projections, we still won't get sharp rallies in the share price in the near term. There may be a rally in the long term, as I expect earnings to grow and the earnings multiple to fall from these levels. In the short term, I don't see out-performance. So, before you invest remember to "start with the end goal in mind".
To sum up, I believe McDonald's at this point would only suit the long term investor, as over the long term one can dollar cost average. However over the short term, the stock doesn't look appealing to me. The recent spike in the share price has pumped up the earnings multiple and although meaningful earnings growth is predicted over the next few years, I don't see the share price following suit. Earnings per share doubled between 2007 and 2009 but the share price didn't move. I expect something similar for McDonald's in the near term.