ModernGraham Valuation: McDonald’s Corporation (MCD)

Company Profile (obtained from Google Finance): McDonald’s Corporation franchises and operates McDonald’s restaurants in the global restaurant industry. These restaurants serve menu at various price points providing value in 119 countries globally. All restaurants are operated either by the Company or by franchisees, including conventional franchisees under franchise arrangements, and developmental licensees and foreign affiliated markets under license agreements. Under the conventional franchise arrangement, franchisees provide a portion of the capital required by initially investing in the equipment, signs, seating and decor of their restaurant businesses, and by reinvesting in the business over time. As of December 31, 2012, 34,480 restaurants in 119 countries at year-end 2012, 27,882 were franchised or licensed (including 19,869 franchised to conventional franchisees, 4,350 licensed to developmental licensees and 3,663 licensed to foreign affiliates (primarily Japan) and 6,598 were operated by the Company.

Defensive and Enterprising Investor Tests (What is the significance of these tests, and what is PEmg ratio?):

Defensive Investor – must pass at least 6 of the following 7 tests: Score = 5/7

1. Adequate Size of Enterprise – market capitalization of at least $2 billion – PASS
2. Sufficiently Strong Financial Condition – current ratio greater than 2 – FAIL
3. Earnings Stability – positive earnings per share for at least 10 straight years – PASS
4. Dividend Record – has paid a dividend for at least 10 straight years – PASS
5. Earnings Growth – earnings per share has increased by at least 1/3 over the last 10 years using 3 year averages at beginning and end of period – PASS
6. Moderate PEmg ratio – PEmg is less than 20 – PASS
7. Moderate Price to Assets – PB ratio is less than 2.5 or PB x PEmg is less than 50 – FAIL

Enterprising Investor – must pass at least 4 of the following 5 tests or be suitable for a defensive investor: Score = 3/5

1. Sufficiently Strong Financial Condition, Part 1 – current ratio greater than 1.5 – FAIL
2. Sufficiently Strong Financial Condition, Part 2 – Debt to Net Current Assets ratio less than 1.1 – FAIL
3. Earnings Stability – positive earnings per share for at least 5 years – PASS
4. Dividend Record – currently pays a dividend – PASS
5. Earnings growth – EPSmg greater than 5 years ago – PASS

Valuation Summary (explanation of the ModernGraham valuation model):

Key Data:

Balance Sheet – 9/30/2013 (an Introduction to the Balance Sheet)

Earnings Per Share – Diluted

Earnings Per Share – Modern Graham

Conclusion:

McDonald’s looks good when you consider the company only from a valuation perspective, after achieving earnings growth from an EPSmg (normalized earnings) of $2.62 in 2008 to an estimated $5.21 in 2013.  However, the company’s financials are not strong enough for either the Defensive or Enterprising Investor because the company holds too much debt at this time.  If McDonald’s could reduce the amount of debt on its books and improve its current ratio from a meager 1.24 to 1.5, then it would become much more attractive.  As it stands, Intelligent Investors can only speculate as to the intrinsic value of the company and should do considerable further research before making any investment into McDonald’s.

What do you think?  Is McDonald’s undervalued or does Mr. Market have it right?  Should the company only be considered speculative?  Leave a comment or mention @ModernGraham on Twitter to discuss.

Disclaimer:  The author did not hold a position in McDonald’s at the time of publication and had no intention of purchasing a position in the next 72 hours.

Photo Credit:  Andrew Magill