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.

Comments
Insider Monkey Small Cap Strategy
Insider Monkey Small Cap Strategy

Insider Monkey beat the market by 52 percentage points in 24 months. Our beta is only 1.2 (don't click this link if beating the market isn't important to you).

Lists

Richest Doctors in the World

The Best Movie Sountracks Ever

The Highest Grossing Musicals on Broadway

The Most Successful Reality TV Stars

Cheapest Cities to Visit in the US

Most Expensive Summer Camps

Most Expensive Animals in the World

Most Expensive Specialty Crops in the World

Movies That Took Ages to Make

The Longest Hollywood Films Ever Made

Most Expensive Concert Stages

The Richest Bands of all Time

10 Most Corrupt Countries 2013 List

10 Countries with the Highest Quality of Life Index

Most Expensive Mattresses in the World

5 Smallest Countries by Land Area

The Ultimate Heartbreak Songs

Richest Teenagers in the World

10 Most Haunted Places in America

10 Best Places to Retire in Florida East Coast

Top 10 Places to See Before You Die

Top 8 Countries in the World Where Justice Prevails

10 Richest States in America

15 Wealthiest Countries in the World

Richest Singers in the World

Most Expensive Tasting Menu in New York City

Most Expensive Baby Items in the World

Most Expensive Hotel Suites in Vegas

Most Expensive Brunch in New York City

Most Expensive Beef Cuts in the World

25 Best Colleges to Get a Job

Top 10 US Supermarkets

The 25 Most Dangerous Cities in the World to Visit

Most Expensive Xbox Games

Top 11 Cities Where Billionaires Live

Top 10 Most Charitable Companies in America

Most Expensive Seafood in the World

The 10 Wildest Conspiracy Theories

The 10 Best Job Markets in the US

Top 10 Accounting Scandals of All Time

The 25 Biggest Cities in the World

Top 10 Best Paying Virtual Jobs

Most Expensive Leather Shoes in the World

Top 6 Things to Buy in March

The 10 Most Stressful Jobs in America – 2014 List

Top 10 Jobs for Introverted People

Top 10 Honeymoon Destinations in the World

Top 10 Highest Paying Jobs in the World

Most Expensive Day-Care in New York City

The 10 Cheapest Places to Retire Abroad

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!