There are many things you can do with your money.
Save it, spend it, gamble it, give it away, etc.
But what’s the very best thing you can do with your money?
Generally speaking, I think there’s only one answer to that question.
I know investing has done just that for me.
I was able to retire in my early 30s, as I describe in my Early Retirement Blueprint.
Investing was a major part of my success.
But it’s not just any ol’ investing.
I specifically invested in high-quality dividend growth stocks like those you can find on the Dividend Champions, Contenders, and Challengers list.
And I built my real-money FIRE Fund in the process.
That six-figure stock portfolio produces the five-figure passive dividend income I live off of.
This strategy advocates buying and holding shares in world-class enterprises that pay reliable, rising dividends.
It’s an intuitive strategy.
After all, it doesn’t make sense to invest in low-quality companies that can’t produce rising profit.
And shareholders, being the collective owners of a publicly-traded company, should receive some of the growing profit their business generates.
The price of a stock is only what it costs. It’s value that tells you what you’re getting for your money.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Investing your money into high-quality dividend growth stocks when they’re undervalued can, and most likely will, positively and radically change your life.
The good news is, spotting undervaluation isn’t as difficult as it might seem.
Lesson 11: Valuation, part of an series of “lessons” on dividend growth investing put together by fellow contributor Dave Van Knapp, explicitly lays out how to go about valuing almost any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
McDonald’s Corp. (MCD) is a quick-service restaurant chain that operates worldwide.
Founded in 1940, McDonald’s is now a $159 billion (by market cap) global fast-food leader that employs over 200,000 people.
By many measures, McDonald’s is the largest fast-food chain operator in the entire world. Across almost 40,000 systemwide restaurants, they purvey their burgers, sandwiches, and beverages to millions of customers every single day.
FY 2019 revenue is split across three global business segments: International Operated Markets, 54%; U.S., 37%; International Developmental Licensed Markets & Corporate, 9%.
There’s almost nobody in the world that isn’t familiar with McDonald’s. This is one of the most well-known brands on the planet.
People have to eat. And investing in that theme seems like a pretty straightforward concept.
Well, investing in the world’s largest provider of fast food is a common idea that has yielded uncommon profits.
That’s because McDonald’s is special. They’re expert at providing a global customer base with quality food at a great value, at a very high level of consistency and speed.
Consumers know exactly what they’re going to get when they patronize a local McDonald’s restaurant.
Perfecting a mixture of quality, value, consistency, and speed has turned McDonald’s into a venerable business that has done extremely well for decades.
But it gets even better.
The company operates mostly through a franchise system. Franchisees run local McDonald’s restaurants.
These franchise arrangements often include a lease and a license, which provide the company of McDonald’s payment of initial fees, as well as continuing rent and royalties.
This is an attractive business model. McDonald’s is essentially one of the world’s largest landlords, with a steady stream of restaurant royalties underpinning all of that.
It’s a one-two punch that almost cannot lose.
And this rent-royalty combo, built on the foundation of the world’s largest fast-food chain, bodes well for the future.
Shareholders should expect profit and dividends to continue to flow and grow for decades to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, McDonald’s has increased its dividend for 45 consecutive years.
That puts them in rarefied company, especially in the hypercompetitive restaurant space.
The 10-year dividend growth rate is 8.4%.
That’s paired with the stock’s current yield of 2.49%.
While this is right in line with the stock’s own five-year average yield of 2.50%, the important consideration here is that it’s a market-beating dividend from one of the world’s best businesses.
The dividend payout ratio of 78.8% is a bit high, which will likely moderate future dividend growth, but it’s secure income for shareholders.
Keep in mind, too, that this payout ratio is based on TTM EPS, which has been affected by the pandemic. This ratio will likely lower once the business normalizes.
I tend to consider a yield of between 2.5% and 3.5%, paired with a high-single-digit dividend growth rate, to be the “sweet spot” for dividend growth investors. This stock is right there.
Revenue and Earnings Growth
That said, these metrics are backward-looking in nature.
But investors are risking today’s capital for tomorrow’s rewards. It’s tomorrow’s dividends and growth that we care about.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help us to estimate the stock’s intrinsic value.
I’ll first show you what McDonald’s has done over the last decade in terms of top-line and bottom-line growth.
And I’ll then compare that to a near-term professional prognostication for profit growth.
Combining the proven past with this future forecast should tell us quite a bit about where the business might be going.
McDonald’s has seen its revenue decrease from $24.074 billion in FY 2010 to $21.077 billion in FY 2019.
A decrease in revenue is not what I like to see.
However, this is due to a change in the business model. McDonald’s started a refranchising plan years ago that saw a lot of company-operated stores move to the franchise model.
This short-term disruption to revenue comes at the long-term benefit of a more stable fee-based business with higher margins and less company overhead.
Meanwhile, earnings per share moved from $4.58 to $7.88 over this period, which is a CAGR of 6.21%.
Very solid bottom-line growth here, particularly when considering the sheer size of the company.
The aforementioned margin expansion has helped.
And a rather substantial buyback program has definitely propelled some of this excess bottom-line growth.
For perspective, the outstanding share count is down by approximately 29% over the last decade.
Looking forward, CFRA is anticipating that McDonald’s will compound its EPS at an annual rate of 7% over the next three years.
That would be pretty close to what McDonald’s has put up over the last 10 years.
While the business has suffered from COVID-19, CFRA sees a very sharp rebound in store.
Here’s what they have to say about the near term: “With plans to open another 1,300 restaurants in 2021 (mainly in the U.S. and China) and further recovery in comparable sales, we expect a rebound to nearly 14% revenue growth in 2021.”
In addition, the pandemic has given the company latitude to experiment with and expand its service channels. In particular, the company will surely benefit over the long run from an expansion in delivery services.
I suspect a quick return to the status quo, or better, is very much in the cards for McDonald’s. After all, the groundwork around refranchising has already been laid.
Indeed, one could argue that bottom-line growth will accelerate coming out of the pandemic.
Either way, we’re looking at high-single-digit dividend growth for the foreseeable future. Again, this is the “sweet spot”.
Moving over to the balance sheet, this is the only area of the business that somewhat troubles me.
The company used to have an amazing balance sheet. But they’ve taken on debt in recent years, partially in order to fund buybacks.
There is no long-term debt/equity ratio here – common equity is negative, due to the high amount of treasury stock from those buybacks.
But a long-term debt load of over $34 billion is quite a bit higher than it was only a few years ago.
On the other hand, the interest coverage ratio of over 8 for FY 2019 indicates no issues with the interest costs.
Their long-term debt commands investment-grade ratings from both Standard & Poor’s (BBB+) and Moody’s (Baa1).
Profitability is a bright spot, in my view. Margins have expanded nicely of late.
McDonald’s is a world-class business that is really in its own league.
And with global scale, unrivaled brand recognition, pricing power, and a unique position in the marketplace, the company does benefit from considerable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
In particular, the fast-food arena is hypercompetitive.
Being a global business, McDonald’s is exposed to currency exchange rates.
The company’s size does, in some ways, work against them. It’s a mature business, which can limit growth.
The long-term impacts from COVID-19 on quick-service restaurants are still unknown.
And input costs, like meat, can be highly variable.
Even after being made aware of these risks, I still believe this is a compelling long-term investment idea.
And with the valuation being where it’s at, the stock is made to be even more compelling…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 31.59.
At first glance, that’s high.
However, this is based on TTM GAAP EPS. Like a lot of other businesses, McDonald’s has been negatively impacted by the pandemic.
The question is whether or not this is a permanent hit to earnings. I suspect it is not.
Likewise, the P/CF ratio of 25.2 looks a tad rich relative to its three-year average of 22.2.
Once earnings and cash flow rebound to normal levels, I think the stock will look cheap. Of course, the stock’s price could (and perhaps will) take off in anticipation of that normalization, leaving this current opportunity in the dust.
Notably, the stock’s yield, as noted earlier, is right in line with its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.
This DGR is on the high end of what I ordinarily allow for. If there’s any business in the world that deserves the benefit of the doubt, it’s this one.
I’m basically splitting the difference between the demonstrated 10-year DGR and what the business has done in terms of bottom-line growth over the last decade. My 7.5% DDM DGR is right in the middle.
I think it’s also worth pointing out that this is fairly close to CFRA’s near-term EPS growth projection, which could actually prove to be conservative.
The DDM analysis gives me a fair value of $221.88.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
I don’t think I was being overly aggressive with my valuation, yet the stock looks at least modestly undervalued.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates MCD as a 4-star stock, with a fair value estimate of $236.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates MCD as a 4-star “BUY”, with a 12-month target price of $250.00.
I came out a bit low. Averaging the three numbers out gives us a final valuation of $235.96, which would indicate the stock is possibly 14% undervalued.
Bottom line: McDonald’s Corp. (MCD) is a high-quality company with unrivaled scale and brand recognition. It’s a classic blue-chip stock that I regard as a must-own for long-term dividend growth investors. With a market-beating dividend, inflation-beating growth, almost 50 consecutive years of dividend raises, and the potential that shares are 14% undervalued, this could be your opportunity to invest in one of the very best businesses you’ll ever find.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from DTA: How safe is MCD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 77. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, MCD’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
This article first appeared on Dividends & IncomeWe’re Putting $2,000 / Month into These Stocks
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