We’re big fans of McDonald’s in this environment (NYSE:MCD)

Alexander Farnsworth

By Valuentum Analysts

At Valuentum, we use discounted cash flow analysis as the basis of our process. However, we also use relative valuation and technical and momentum indicators and blend them into an output called the Valuentum Buy Index Rating, or the VBI. Evaluation. The image below shows the order of our systematic process.

Au centre du diagramme de Venn ci-dessus, l'indice d'achat Valuentum (<span>VBI</span>) combines rigorous financial and valuation analysis with an assessment of a company’s technical characteristics and momentum indicators to derive a score between 1 and 10 for each company (10=best).  Since the process takes into account a technical and dynamic evaluation after evaluating a company’s investment merits through a rigorous DCF and relative value process, the VBI attempts to identify entry and exit points on what we consider to be the most undervalued stocks.” contenteditable=”true” loading=”lazy”/></picture><figcaption>
<p class=At the center of the Venn diagram above, the Valuentum Buy Index (VBI) combines rigorous financial and valuation analysis with an assessment of a company’s technical and momentum indicators to derive a score between 1 and 10 for each company (10 = best). Since the process takes into account a technical and dynamic evaluation after evaluating a company’s investment merits through a rigorous DCF and relative value process, the VBI attempts to identify entry and exit points on what we consider to be the most undervalued stocks. (Image source: Valuentum)

The flowchart on how we classify stocks in our universe of coverage.

The flowchart on how we classify stocks in our universe of coverage. (Image source: Valuentum)

McDonald’s (NYSE: MCD) currently scores a 3 on the Valuentum Buy Index based on three of its key investment considerations which we will discuss shortly (and as seen in the image below). We use the Valuentum Buy Index to find ideas for the Best Ideas newsletter simulated portfolio. Although we like McDonald’s very much in any environment, we believe it is uniquely positioned to benefit from the current inflationary environment.

First, the company runs a predominantly franchise business model, which means that most inflationary headwinds on the cost front can impact its operators, as the company benefits from higher selling prices from free franchises. Second, McDonald’s offers tremendous value to the consumer, and its 2 for $2 offer is just one example. Consumers can’t get enough of Mickey D’s. With that background clearly laid out, let’s now dive deeper into our fundamental, cash flow and valuation analysis of McDonald’s.

Key McDonald’s Investment Considerations

Investment Considerations

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Home of the Big Mac, McDonald’s is the world’s largest fast food brand. The company’s management is extremely shareholder-friendly, returning billions to shareholders every year. McDonald’s has more than 40,000 restaurants in approximately 120 countries. The company was founded in 1940 and is based in Oak Brook, Illinois.

At the end of December 2021, approximately 93% of the company’s restaurants worldwide were franchised. McDonald’s aims to generate a free cash flow conversion rate north of 90% in the near term, aided by the sluggish nature of its business model.

While it’s hard to produce another gem with the same success as McCafe, we can’t rule out McDonald’s. Industry-wide traffic trends and competitive pricing in the United States are worth noting when it comes to competitive performance. McDonald’s seeks to franchise approximately 95% of its total number of restaurants, which should further support its financial performance.

McDonald’s is modernizing its stores and improving its digital operations, while encouraging its franchise partners to do the same. The company continues to optimize its menu while improving the in-store dining experience and digital order delivery experience. McDonald’s has great growth prospects.

Labor market and wage developments are worth watching, and growing competition from fast and healthier menus is a permanent structural change. McDonald’s relies on its pricing power to offset inflationary headwinds.

McDonald’s released its third quarter 2022 results on October 27, and we couldn’t have been happier with the results. Worldwide comparable sales rose 9.5%, easily beating the consensus forecast of 5.8%. Consumers continue to flock to its locations to find value-added offers, and many high-income customers may be looking to redeem to its offers. It recently increased its dividend payout by 10%, and we management’s commitment to the payout.

McDonald’s Cash Flow Valuation Analysis

Cash flow generation

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We think McDonald’s is worth $245 per share with a fair value range of $190 to $300. The shares are priced at $258 at the moment, which is roughly the midpoint of our fair value estimate range. We point to the upper end of our fair value estimate range given the momentum McDonald’s seems to have in the current environment.

The margin of safety around our estimate of fair value is determined by the company’s MEDIUM ValueRisk™ rating, which is derived from an assessment of the historical volatility of key valuation factors and a future assessment of these. .

Our near-term operating forecasts, including revenue and earnings, do not differ materially from consensus estimates or management guidance. Our valuation model reflects a compound annual revenue growth rate of 6.2% over the next five years, a pace higher than the company’s historical compound annual growth rate of 3.4% over 3 years.

Our model reflects a projected 5-year average operating margin of 47.3%, which is above McDonald’s 3-year average. Beyond year 5, we assume that free cash flow will grow at an annual rate of 4.4% for the next 15 years and 3% in perpetuity. For McDonald’s, we use a weighted average cost of capital of 8.5% to discount future free cash flow

McDonald's Valuation Assumptions

McDonald’s valuation assumptions (Image source: Valuentum)

McDonald’s Margin of Safety Analysis

Range of potential results

Image source: Valuentum

Our discounted cash flow process evaluates each business based on the present value of all future free cash flows. Although we estimate the fair value of McDonald’s at approximately $245 per share, each company has a range of likely fair values ​​that is created by the uncertainty of key valuation factors (such as future revenue or earnings, for example). . After all, if the future were known with certainty, we wouldn’t see much volatility in the markets, as stocks would trade precisely at their known fair values.

Our ValueRisk Rating defines the margin of safety or range of fair value we assign to each stock. In the chart above, we show this likely range of fair values ​​for McDonald’s. We think the company is attractive below $190 per share (the green line), but quite expensive above $300 per share (the red line). Prices that fall along the yellow line, which includes our estimate of fair value, represent a reasonable valuation for the business, in our view.

That said, in light of current inflationary conditions, we wouldn’t be surprised to see McDonald’s do extremely well, pushing its fair value up the designated range. In our view, investors may be looking for upside potential in valuations.

Final Thoughts

McDonald’s has been doing well lately. The company’s move to make breakfast an all-day proposition has reinvigorated same-store sales growth (it has since discontinued all-day breakfast, but company-wide momentum company continued), and its efforts to refranchise company-owned restaurants and pursue net annual G&A expense reductions are doing wonders on its operating profit line. No other restaurant chain can match its iconic brand, geographic reach and advantages of scale, and it has increased its dividend every year since the first payout in 1976, although it is not immune to the industry-wide traffic and competition. price issues. McDonald’s continues to innovate and has great growth prospects.

McDonald’s is simply a fantastic restaurant concept. The company is executing its turnaround plan perfectly, in our opinion. His goal of becoming 95% franchised over the long term, however, should shield him from most operating problems (including inflationary pressures), but franchisees are a fickle bunch, and management will need to stay on their toes strategically, especially given the barriers created by COVID -19. Consumer trends can change quickly and the restaurant now has a much larger net debt, which is why its Dividend Cushion ratio is under pressure. Still, we like stocks in this environment, and with a dividend yield of around 2.4%, the company is one of our favorite ideas.

This article or report and any links it contains are for informational purposes only and should not be considered a solicitation to buy or sell securities. Valuentum is not responsible for any errors or omissions or results obtained from the use of this article and assumes no responsibility for how readers may choose to use the content. Assumptions, opinions and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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