McDonald’s Corporation (MCD): This Stock Isn’t as Expensive as it Appears

It’s easy to overlook a boring blue-chip stock in favor of a faster growing company. However, many investors make the mistake of assuming that a blue-chip company can’t provide superior returns.

McDonald's (MCD)This was the mistake that I made with McDonald’s Corporation (NYSE:MCD). I was more enamored with fast growing concepts like Buffalo Wild Wings (NASDAQ:BWLD), Chipotle Mexican Grill, Inc. (NYSE:CMG), and Panera Bread Co (NASDAQ:PNRA). I looked at McDonald’s expected growth rate of less than 10% as a waste of time, next to companies that might grow their earnings by 19% or 20% in the next few years. However, what I missed was the power of the company’s cash flow, and what a difference a good dividend makes.

Would You Like Two Ways to Make Money or Just One?
When you buy a growth stock, unless you are going to write options or make some other bet, you only make money if you sell the shares. When you buy a company that pays a dividend, you may make money when you sell the shares, but you also get paid even if the shares stay flat. If investors use dividend reinvestment, the change in their effective yield can be significant.

Five years ago, McDonald’s stock was selling for about $60 a share. At that time, the dividend yield was about 2.5%. In the last five years, the company has increased the dividend from an annual payout of $1.50 to $3.08. This means if you bought at $60, your effective yield is 5.13%. If you reinvested your dividends over that five year timeframe, your yield would be even higher. If your yield is already over 5% in the last five years, imagine what would happen if you bought 10 or 20 years ago.

The point is, a company with a growing dividend can provide both current income and potential capital gains. A company with no dividend can provide capital gains, or you could end up waiting around and losing money if the stock doesn’t go up.

This ‘Boring’ Business Makes a Lot of Money
In the restaurant industry, companies come and go, and yet McDonald’s finds new ways to grow. While the company’s current quarter earnings only showed diluted EPS up 4%, this was in a very difficult environment internationally. No matter what is going on, there are two things that McDonald’s does better than almost anyone.

First, McDonald’s has a gross margin that is the envy of most of the industry. In the current quarter, the company’s gross margin was 39.24%. The only company in its peer group to perform better was Starbucks Corporation (NASDAQ:SBUX) with a gross margin of 57.35%. However, the fact that Starbucks is known for its upscale coffee offerings, and McDonald’s is known for its dollar menu makes this comparison a bit unfair.

Yum! Brands, Inc. (NYSE:YUM) is a better comparison, and that company only managed a 28.75% gross margin in the current quarter. Looking at a few of the faster growing chains, Panera Bread’s gross margin is 34.52% and Chipotle’s is 24.57%. As you can see, anywhere near its price range, McDonald’s gross margin far outstrips the competition.

McDonald’s higher gross margin leads to significant free cash flow, and by one measure, no other company does better. In the current quarter, McDonald’s generated an estimated $0.14 of free cash flow per dollar of sales. Since McDonald’s didn’t provide an actual cash flow statement, this is based on the company’s net income, plus normal depreciation, minus the company’s last quarter capital expenditures. Using the same measure, Yum Brands generated $0.10 of free cash flow per dollar of sales. By comparison, Starbucks generated $0.09 of free cash flow, Panera generated $0.04, and Chipotle generated $0.03.

What About Valuation?
Another reason some investors avoid companies like McDonald’s is their valuation. Amateur investors use the PEG ratio, and see that McDonald’s PEG is higher than many of their competitors. However, the PEG ratio is incomplete when you are looking at dividend paying companies. What I prefer to use is the PEG+Y ratio. This ratio, which was introduced to me by Peter Lynch’s books, adds the company’s growth rate to their dividend, and divides by the P/E ratio. Think of this number as an inverted PEG ratio, and remember the higher the better.

Many would choose Chipotle or Yum Brands over McDonald’s based on PEG ratio. However, using PEG+Y, the numbers change a bit. McDonald’s PEG+Y is 0.75 from the following calculation (8.89% growth rate + 3.28% yield = 12.17% total return / 16.22 P/E = 0.75). Chipotle’s PEG+Y ratio is 0.66 and YUM Brands ratio is 0.68. As you can see, even though Chipotle and Yum Brands are expected to grow faster, they are relatively more expensive.

Starbuck’s PEG+Y is 0.80 and Panera Bread’s is 0.84, which are both better than McDonald’s, but they both rely on faster earnings growth rates to achieve these results. If either chain fails to grow as fast as analysts expect, their ratios would drop.

McDonald’s higher yield, better free cash flow generation, and history of raising the dividend makes the choice more difficult than it first appears. The bottom line is, investors need to be careful to not assume a “boring” blue-chip doesn’t belong in their portfolio. Sometimes the most boring businesses can be the most exciting investments.

The article This Stock Isn’t as Expensive as it Appears originally appeared on Fool.com and is written by Chad Henage.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

blog comments powered by Disqus
Insider Monkey Headlines
Insider Monkey Small Cap Strategy
Insider Monkey Small Cap Strategy

Insider Monkey beat the market by 52 percentage points in 24 months Click to see monthly returns in table format!

Lists

The 10 Worst Mistakes an Entrepreneur Can Make

The 5 Most OP Characters in League of Legends to Carry Games and Crush Foes With

The 5 Best Foods to Eat Before Running that Will Help You Pound the Pavement

10 Glaring Plot Holes in The Walking Dead that a Zombie-Filled Bus Could Drive Through

The 5 Biggest Celebrity Stoners Who Love Their Reefer

The 10 Most Overrated Movies Of All Time by Out-of-Touch Critics

Top 6 Least Expensive Cruise Destinations For 2015 that Will Take You to Paradise

10 States with Lowest Substance Abuse Rates in America

The 14 Most Watched TV Finales Ever

The 10 Best Selling Role Playing Games of All Time for PC

10 Most Influential Papers In Economics

Top 8 Biggest Charities in the US

10 Worst Celebrity Career Moves Ever

Top 10 Best Paid Tennis Stars in the World

10 Cities with High Demand for Nurses

6 of the Worst Greeting Card Messages Ever Crafted

How to Make Money in ArcheAge and Build Your Empire

10 Foods To Eat To Lower Cholesterol Levels

The 10 Most Hated Television Characters of All Time

The 30 Worst Halloween Costume Ideas Ever Brought to Horrible Life

10 Vocational Skills in Demand Today with Jobs Waiting to be Filled

10 Best Places to Visit in Central and South America

The 10 Greatest Empires in History Which Nearly Conquered the World

The 6 Cheapest Boarding Schools In America 2015

5 Clear Reasons LoL is Better than DotA, Continues to Rule MOBAs

The Only 9 Teams with a Chance to Win the Super Bowl

The 15 Most Common Phobias in America that Induce Fits of Panic

Top 6 Least Expensive Tourist Destinations in 2014

Jim Goetz, Peter Fenton, Jim Breyer: Top 6 Venture Investors for 2014

Top 15 Billionaires in 2014

5 Pitfalls To Avoid When Buying a Franchise

Top 20 Medical Schools in the US – 2014 Rankings

4 Business Strategies that Turned Jamie Oliver into the World’s Richest Chef

6 Qualities That Make You A Good Team Player

10 High Paying Seasonal Jobs in America this Holiday Season

The 10 Busiest Shipping Lanes in the World

5 Most Valuable Brands in China

The 10 States with Highest Substance Abuse Rates Crippling Their Populace

The Top 10 Things to Do Before You Die That Will Echo for Eternity

The 10 Best Selling Items on Etsy

Top 10 Things to Do in Tokyo, the Greatest City in the World

10 Mistakes on Social Media that Can Harm You and Will Probably Get You Canned

The 10 Best Cities to Find Jobs in 2014

The 10 Most Controversial Songs Of All Time to Hit (and get Banned from) the Airwaves

The 20 Biggest IPOs in US History

The 10 Best Places to Visit in Mexico that Are Beautiful and Safe

7 Bad Habits that Age You Beyond Your Years

The 40 Best Fortune Cookie Sayings That Will Leave You Bemused, Befuddled, or Beguiled

10 Foods to Eat Before a Workout to Make Every Drop of Sweat Count

The 5 Best Documentaries On Netflix You Must See

Subscribe

Enter your email:

Delivered by FeedBurner

X

Thanks! An email with instructions is sent to !

Your email already exists in our database. Click here to go to your subscriptions

Insider Monkey returned 47.6% in its first year! Wondering How?

Download a complete edition of our newsletter for free!