McDonald’s Corp.'s (MCD, Financial) transformation over the last several years has been remarkable as the company changed course, improved its menu and got traffic to flow back into its stores. As comparable store sales picked up momentum, the stock price has been on a roll and is now up by nearly 42% in the last year. It continues to rise with every quarter of positive earnings. Is McDonald’s a good buy at this price point?
From a dividend perspective, the 2.3% yield looks decent. Considering the current direction of the company, which is to achieve a 95% franchised restaurant ratio, McDonald's is planning to become a low-risk cash flow generator, which makes it a great fit for dividend investors. But the stock is trading at 5.4 times sales and 26 times earnings, a high valuation for a fast-food restaurant chain.
The root of the problem is sales will continue to decline as McDonald’s moves from the current 85% franchised restaurant ratio toward 95%. Although the bottom line and margins will improve during the process, the 26 times trailing 12 months earnings and 23 times forward earnings do not leave much room for the stock to rise over the next several years.
One major reason for the stock’s strong rise last year is the company kept surprising the market by beating earnings estimates quarter after quarter. Over the last three quarters, the stock price swelled from $120 to the current $158 per share on the back of strong earnings reports.
The high franchise ratio McDonald's is targeting will make the company’s revenue extremely stable in the future. But long-term growth will be extremely hard to come by. That’s the tradeoff the restaurants who take the franchisee route have to accept. The strategy makes a lot of sense because the company already has more than 35,000 stores globally, and the room for further growth is limited. By taking the highly franchised option, McDonald's is cutting down a lot of the risk a company of its size faces when it tries to run everything on its own.
Between 2015 and 2016, McDonald’s total revenues declined from $25.41 billion to $24.62 billion, but operating income increased from $7.146 billion to $7.745 billion.
As McDonald's moves toward a franchise model, sales will come down and margins will go up, a phenomenon that is already underway. In the long term, sales growth will be slow but steady at best because franchisees will only a pay a certain percentage of sales to McDonald’s.
The problem with the current sales and earnings multiples is they leave no margin for error and most of the future growth and profits seem to be already priced in. McDonald’s is a good company for dividend investors, but investors should not chase the stock at the current price. Rather, move in after a quarter of bad news. Patience will be key if you want to invest in McDonald’s.
Disclosure: I have no positions in the stock mentioned above, and no intention to initiate a position in the next 72 hours.
