By Ee Hsin Kok. Edited by Arjun Chandrasekar.
McDonalds is a fast-food restaurant chain founded in 1955. Since then, it has grown to be the world’s largest fast-food restaurant chain and as of July 31st, 2021, has a market cap of around $181 billion. In this article, we will be analyzing the company and evaluating whether it might be a good investment decision for you.
Whenever you choose to invest in a company, you want to ask yourself “why?”. In the case of McDonalds, there’s a pretty simple reason to invest in it: stability.
McDonalds has an enormous economic moat and name brand. If you ask anyone to name a fast food restaurant off the top of their head, chances are McDonalds will be their first answer. With over 39,000 restaurants worldwide in over 130 countries, McDonalds is currently the largest fast food restaurant chain in the world and definitely isn’t going to disappear for a while.
McDonalds is also able to generate steady cash flow even during times of economic depression and faltering sales because it operates on a franchise model. Over 90% of McDonalds restaurants are franchised and McDonalds holds over $30 billion in real estate holdings. They rent out buildings to franchises, allowing for consistent cash flow even when sales may drop. Breaking down the franchise fees McDonalds collects, over 60% of their income is from rent, while royalties only make up about 36%. This makes McDonalds an incredibly predictable and defensive company. Franchise takes all the risk, while McDonalds still reaps the rewards!
When you take a look at the balance sheet for McDonalds, you might actually be scared because the company has negative shareholder’s equity! But you shouldn’t be. The reason behind its negative equity is that McDonalds has taken on debt to leverage extremely low interest rates and increase share buybacks. While a negative shareholder’s equity may be concerning for smaller or less predictable companies, for a company like McDonald’s it really isn’t. Due to the company’s name brand and franchise model, McDonalds is able to guarantee consistent cash flow. In fact, its debt servicing ratio is around 18%, which is pretty safe.
Growth Drivers and Valuation
The global fast food market is expected to grow at a compounded annual growth rate (CAGR) of 4.5% until 2027. Additionally, McDonalds has been going increasingly digital, selling through their McDonald’s app. This is especially important as with the secular growth of technology, most things are moving online, especially food delivery. Over the past 5 years, McDonalds has had an annual earnings growth rate of 5.6%; but over the next 5 years, due to its growth drivers and with the coronavirus pandemic coming to an end, it is expected to grow around 8.8% according to Simply Wall Street and 8.7% according to Zacks. If we use an 8.8% growth rate for the first 10 years, followed by a 4.2% growth rate for the final 10, then a 20 year discounted cash flow valuation method would produce an intrinsic value of around $225, which is quite close to Morningstar’s valuation of $234.
McDonald’s has been around a long time. It was once a fast grower but has since slowed down to be a stalwart. Over the past 21 years, McDonalds has gained over 600% compared to 200% for the S&P 500 index; and since 2015, McDonalds has gained 160% compared to 115% for the S&P 500 index. This tells us that McDonalds has a good track record of outperforming the S&P 500, an important sign of an outstanding company.
Is it a Good Investment Right Now?
As of today, McDonald’s has a market price of around $240, a little over its intrinsic value of $225 to $234. McDonald’s is a phenomenal company with an ingenious business model. But at its current price, it’s not the best investment. However, should its price drop to $220 or lower, you’d be hard-pressed to find a better stalwart/predictable company to invest in.