🍔Business Overview

🎯Key Metrics

Total: 9.5/17

• +2 ✅✅ Projected Operating Margin: 51.49%
• +0 ⚠️ Projected 5-Year Revenue CAGR: 4.42%
• +2 ✅✅ Last 5-Year ROIC: 26.37%
• +1 ✅ Estimated Cost of Capital: 8.44% (less than ROIC)
• +1 ✅ Last 5-Year Shares Outstanding CAGR: -1.20%
• -1 ❌ Projected 5-Year EPS CAGR: 7.98% (given the ease of manipulating earnings metrics, sub-10% growth warrants caution)
• +0 ⚠️ Projected 5-Year Dividend CAGR: 6.08%
• +0.5 ✅ Moody’s Rating: Baa1
• +2 ✅✅ Morningstar Moat: Wide
• +2 ✅✅ Morningstar Uncertainty: Low

📈McDonald’s is unique. Its fast food franchise has taken the world by storm (for a long time now) and its “tasteful” uniqueness and wide moat is shown on its stellar projected operating margins of around ~50%. This margin expansion projection, from the current 40-45%, is also justified by the fact that this is one of the companies that will take advantage of the AI to improve its efficiency and increase its margins in the process. It is also a very stable business and with stellar good capital allocation, returning (ROIC) around 3 times its cost of capital.

📉Its modest revenue and EPS growth warrants some caution for the enxt couple of years. However, this is also justified by the maturity of the business and its mature growth / decline stage in its lifecycle. I don’t see any competitors or disruption of its business in the horizon, however a new more health focused generation may start to put pressure on the company, it is something to watch out for.

Given all of this, let’s check its current valuation to see if its market price is justified.

📈Business Valuation

To calculate the intrinsic value of the company I’ll use multiple methods:

• Discounted Cash Flows (DCF) – Intrinsic value is estimated by projecting its free cash flows over the next 10 years and discounting them to present value using the estimated cost of capital;
• EPS Growth – the fair value is estimated by projected the Earnings Per Share CAGR for the next 5 Years and then, given its current and historic values of PE, come up with a PE for the 5th Year. This will give us its price 5 Years from now using the formula: Price = EPS x PE that we then discount using the estimated cost of capital;
• Historical P/E – we assume mean reversion to the historical P/E values;
• Historical EV/EBITDA – we assume mean reversion to the historical EV/EBITDA values;
• Historical P/S – we assume mean reversion to the historical P/S values;
• DDM (Variable) – the fair value is estimated by projecting the dividend payments across the following years and discounting them to the present value using the estimated Cost of Capital;
• Historical Dividend Yield – we assume mean reversion to the historical dividend yield.

Cost of Capital

I’ve used the latest annual financial statement of the company, the 10-Year US bonds as the risk free rate and revenue geographic exposure to come up with its cost of capital, cost of debt and cost of equity. Also, given the fact that Moody’s provided a rating for the company I used it as the debt rating.

Cost of Capital: 8.44%.

This value will be used later as a discount rate in the valuation methods.

Please feel free to come up with your own values by using the tool I’ve used: Cost of Capital – The Fair Value Journal. It is and will ever be completely free 🙂

Discounted Cash Flows (Weight: 40%)

I’ve used the latest annual financial statement of the company, the analyst estimates for both revenue and margins and the cost of capital calculated previously.

Some notes on the inputs above:

• Terminal Revenue Growth – I’m using the risk-free rate (10-Yr bonds of US), because long term the company should not grow more than the rate of the economy. I’m using the risk-free rate as a proxy to it, so the terminal growth becomes it;
• Terminal Cost of Capital – I’m assuming the cost of capital converges long term to the industry average;
• Terminal Tax Rate – I’m assuming here that the tax rate converges to the industry average;
• Terminal ROIC – I’m assuming the company will still be able to return above its cost of capital but below its historical averages.

All the other inputs were taken from the financial statement or from analyst projections.

The DCF gives us an estimated fair value of 221.67 dollars for McDonald’s.

Something that we can also do now is to play around with Monte Carlo simulations. What this will allow us to do is to simulate multiple DCF valuations with pre-defined ranges for each of the inputs. Each simulation will randomize the inputs between these pre-defined values. For this I also used analysts estimates.

As you can see from the above McDonald’s seems to be overvalued given that its current price of 328 dollars is well above P90. From these simulations we can extrapolate that there’s more than 90% probability that the stock is overvalued at the current price.

Please be free, as before, to fill in your own values. Make the valuation your own and do yourself a DCF valuation using your own assumptions: DCF – The Fair Value Journal

EPS Growth (Weight: 20%)

For this valuation method, I’ve used the current EPS and the analysts estimates of EPS growth. I also assumed a 23 PE for the company, so a little below its current value and historical averages but still very generous for its projected growth.

Then again, I used the Monte Carlo simulations to check how the estimated fair value changed as my assumptions were modified.

Using this valuation method, McDonald’s that is currently priced at 328 dollars seems to be overvalued being currently valued above P90. From this we can extrapolate that there’s more than 90% probability that the stock is overvalued.

As before, feel free to try this yourself: EPS Growth – The Fair Value Journal

Historical P/E (Weight: 10%)

The current P/E (Price / Earnings) ratio is around its 10 Year average. This means that the company is fairly valued by this metric. Assuming a mean reversion to its historical average of 26.86 we can assume a fair value of 321.28 dollars.

For every type of historical and relative valuation you can use the same free tool: Historical / Relative Valuation – The Fair Value Journal

Historical EV/EBITDA (Weight: 10%)

The current EV/EBITDA (Enterprise Value / Earnings Before Interests, Taxes, Depreciation and Amortization) ratio is above its 10 Year average. This means that the company is overavalued by this metric. Assuming a mean reversion to its historical average of 18.78 we can assume a fair value of 252.03 dollars.

Historical P/S (Weight: 10%)

The current P/S (Price / Sales) ratio is above its 10 Year average. This means that the company is overvalued by this metric. Assuming a mean reversion to its historical average of 7.36 we can assume a fair value of 269.17 dollars.

DDM – Variable Growth (Weight: 5%)

Now we look at a Dividend Discount Model (DDM). This will allow us to value the company, using its dividend payments and the overall growth of it. In this type of DDM we’ll set the dividend to grow at an initial rate that then over time moderates and declines to a given terminal stable growth that will be maintained “forever”.

For the stable growth, I normally use the growth rate of the economy the company is based on, namely the 10-Year bonds of the currency used by that economy country. The same as before, here we’re using the 10 Year bonds of the United States.

As you can see below I started the dividend growth at 6.08% (analysts expectations) and then slowly the growth moderates to 4.09% (the risk free rate – 10-Yr bonds of the US). Also note the use of the Cost of Equity, calculated previously when we also calculated the Cost of Capital.

Why use Cost of Equity and not Cost of Capital as the discount rate for DDM? Its because dividends are paid to equity holders after debt obligations. Since DDM values equity-only cash flows, we use an equity-only discount rate (the Cost of Equity).

Please note that given the fact McDonald’s only returns 60% of its profits in dividends, this method will probably undervaluate the company. Because of this, I kept this valuation method weight at only 5%, despite the long track history of dividend payments. This will allows us to also take into account this but with a sensible weight in our final valuation.

Then, as always, we can also use a Monte Carlo simulation to dive deeper into the valuation 🤓

As you can see from the above McDonald’s seems to be overvalued given that its current price of 328 dollars is well above P90. From these simulations we can extrapolate that there’s more than 90% probability that the stock is overvalued.

Please be free to use the same free tool I’ve created here: DDM (Variable) – The Fair Value Journal

Historical Dividend Yield (Weight: 5%)

The current Dividend Yield ratio is below its 10 Year average. This means that the company is overvalued by this metric. Assuming a mean reversion to its historical average of 2.29% we can assume a fair value of 312.24 dollars.

✍️Summary

Now that we did all the heavy work, let’s take the above and come up with the company weighted average fair value.

I basically take each valuation method used and given my confidence on the company apply a 20% or 10% discount (when to buy) and addition (when to sell) or use the Monte Carlo P10, P20, P80 and P90 values:

Feel free to choose your own values and your own margin of safety, but for me I will start buying McDonald’s shares around the 216.47 dollars mark, given the wide moat and overall stability and low uncertainty of its brand.

Please remember that the fair value estimate has a 100% probability of being wrong and it will never be a precise number, even if it has decimals next to it 😮

Overall it seems McDonald’s is overvalued at the current prices.

Fair Value: 238.97 dollars