In my previous post, I examined the fundamental business performance of McDonald’s over the last 10 year time period.  Based on this analysis, MCD was awarded 3 of 3 stars in the fundamentals category for having an average RoE of greater than 20%, a dividend yield and dividend growth rate that should provide more income than a comparable investment in long corporate bonds over 20 years, and for an adequately covered dividend and moderately leveraged balance sheet.  Continuing with the analysis of MCD, the following post looks at the various valuation metrics that I use to determine whether or not the stock is trading below my buy price.

Rate of Return:

For any investment that I enter into, I have a minimum expected return of 15% per year.  Thus, I am only interested in investing in stocks where the sum of the current earnings yield and the projected earnings growth rate in excess of this hurdle rate.

To calculate the earnings yield, I look at the inverse of the P/E ratio, the Price to FCF ratio, and the EBIT/EV ratio.  Based on data for the trailing twelve months (TTM) and the closing price as of November 19, 2010 ($79.64), these ratios are as follows:

Table 1:  Earnings Yields

Using these three metrics, the median value (5.5%) is adopted as the current earnings yield.

From the fundamental analysis, the forward looking growth rate in free cash flow is estimated at 6.8%.  Therefore, the total return going forward should be 12.3% which is below my cut-off rate of return.  Using this analysis, MCD’s price would have to fall to approximately $58.53 (near its 52-week low) before the rate of return would be above my hurdle rate.  As MCD’s current stock price is above the price necessary to achieve a 15% rate of return, MCD is awarded no stars for this valuation metric.

Dividend Income:

The second metric that I look at is the price necessary to ensure that the dividend income stream over 20 years is greater than the income received by holding corporate bonds.  From the fundamental analysis, the NPV of the difference between the dividend income stream and the interest on the corporate bonds is $522 over 20 years.  To have the dividend income stream equal the corporate bond income, MCD’s price would have to increase to $82.17 which is comfortably above the current stock price.

Additional Metrics:

Though I place most weight on the rate of return and dividend income metrics, I examine a variety of other metrics to ensure that a stock is trading below its fair value buy price.  Based on a 10-year price and earnings history, the high and low values of the P/E ratio, EV/EBIT, Dividend Yield, and Price to Book can be determined as shown in Table 2 below.

Table 2:  10 Year Average Valuation Metrics

Using the TTM earnings data, the current price and dividend yield, the following buy prices can be obtained based on these various metrics.  In addition, the Graham number is presented based on the total book value (including intangibles).

Table 2:  Select Valuation Metrics

Based on these metrics, MCD is trading above its historical averages in all categories.  Using an average of these valuation metrics, fair value for MCD is approximately $59.04.

Summary:

Based on the above metrics, MCD is trading at a premium to its calculated fair value and as such no stars are awarded for valuation (3 out of 4 so far).  Of the metrics discussed above, the most stringent valuation methodology produces a buy price of $58.53.  Thus, I will look to initiate a MCD position only after the stock price declines in the future.

For my next post, I will take a look at some of MCD’s technical indicators.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure: No positions as of the time of this writing.