Is McDonald's still a good buy?

The company has been as steady as anyone could hope, but that doesn't mean it's a good time to buy, especially if you're just looking at price charts.

By Feb 6, 2012 6:19PM

By Julie Carnevale,

McDonald's (MCD) has a consistent record of growing earnings at double-digit rates, and the market tends to price the company's shares within reasonable variations of its earnings achievements.

But is McDonald's is too expensive to buy or hold at current prices?

Utilizing our estimated earnings and return calculator, let's start by looking at our default estimates based on the current consensus of 19 analysts reporting to Capital IQ.

Here we discover two things that are important. First, analysts expect earnings to grow at or below the historical annual average of 10% over the next five years.

The consensus for 2012 earnings growth is only 9%, and the average five-year growth estimate is 10%. Based on the stock's past history, it's logical to assume that there might at least be a moderately negative bias to current estimates.

This seems even stranger when you consider that on Jan. 24, McDonald's reported fourth-quarter earnings growth of approximately 15% -- about the same rate it saw for all of 2011 (note that our graphs are only showing 2011 earnings growth of 14%, marked with an "E" for estimate, as the official data has not yet filtered through the database).

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Assuming that consensus estimates are correct, it would appear that McDonald's shares are currently moderately overvalued (share price more than two years ahead of earnings marked with a red line).

The four lighter colored orange lines, two above and two below the darker orange line, represent what we like to call the value corridor. Notice that the lines are parallel to each other and sloped at the estimated growth rate of 10%.

Also, the appropriate price-to-earnings ratios that apply to each of the lines are listed on the scale to the right of the graph. Therefore, the calculated five-year estimated total return of 8.4% per year assumes that McDonald's does in fact grow earnings at the consensus rate of 10%, and that the market appropriately capitalizes that growth at a P/E of 15.

However, when you consider that McDonald's has grown earnings at 15.7% since calendar year 2007, and that earnings growth in 2011 was also 15%, the consensus estimate of only 10% seems low.

Therefore, utilizing the override feature of the estimated earnings and return calculator, we will recalculate our expectations for McDonald's five-year estimated future growth using its 15.7% historical average. In other words, we are asking "what if" McDonald's continues to grow earnings as it has in the past.

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When we redraw the chart using these numbers, we discover that McDonald's may still currently be fully valued where its price is now sitting near the top of the value corridor (the top light orange line).

However, it would be a stretch to call it overvalued at today’s price levels. Considering that if McDonald's was to continue achieving its historical growth, then the potential for a total annual return of approximately 15% or better becomes very real.

Unfortunately, most investors are forced to rely on charts based solely on stock price in order to determine whether the stock is a good buy, sell, or hold. Consequently, it's very easy to become misled by either a rapidly rising or rapidly falling stock price.

We believe that the only way to really have a clear vision of the appropriateness of investing in any given stock is when price and fundamentals can be viewed simultaneously.

When you examine the 20-year earnings (fundamentals) and price correlated graph on McDonald's, the relationship between fundamentals and stock price can be vividly seen. Therefore, more appropriate buy, sell, or hold decisions can be made based on a sound foundation of fundamentals. This is not to imply that perfect decisions can be made, but we believe it is clear that when price and fundamentals are viewed in concert with each other, a more learned perspective is attained.

When applying these principles to McDonald's current valuation, it appears that McDonald's stock is currently fully priced… but once again, we would stop short of calling it overpriced. Although we would not purchase McDonald's stock at today's prices, we only make that decision based on the belief that sometime in the near future we might be given the opportunity to invest in this blue-chip at a better valuation.

This opinion is founded upon the principles of valuing earnings, and the long-term history of how the market has specifically valued McDonald's earnings. Consequently, we currently rate McDonald's a long-term hold.

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