Is McDonalds Overpriced? Part-1

I can’t think of a stronger and more robust business model than McDonalds (MCD), and who can argue otherwise? This global fast-food giant dominates in almost every country around the world, and is currently expanding voraciously through much of Asia. Travel anywhere around the world, and you will find a McDonalds for a safe and cheap place to eat. McDonald’s has also been a stellar stock to own since January 2003, when it was trading at only $14 per share. Unlike the food it produces, McDonald’s stock is no longer a cheap deal.

McDonalds was one of my Stock Picks for 2011 in December 2010. I also recommended MCD in Three US Stocks For Your RRSP back in October 2010, when MCD was trading at $74.51 per share. The future prospects for McDonalds look excellent and the company looks poised for solid growth in 2012. The Dividend Monk also invested in MCD recently. He’s cautious, but long-term bullish.  I really like McDonalds. I like the business model and I even like the new Angus burger with Bacon – it’s a delightful box of cholesterol. So why would I be crazy enough to even consider selling this winner? Have I lost my dividend marbles?

Earnings, Price, and the Dog on a Leash

Back in 1998 investors also thought McDonalds was a sure thing, which it was, but the price became quickly overvalued. McDonalds reached a high of $45.31 in January 1999, and then declined a whopping (not whopper) 68% to a low of $14.46 in January 2003. While MCD is a solid company, the share price and PE Ratio are once again trading at all time highs. MCD is currently skirting the $100 mark at $98 per share, with a PE Ratio of over 19. While others are buying MCD, I feel this may be either a good time to sell and take profit, or hold on and wait for the dips to buy more. The long term chart of McDonalds below shows a stock that is soaring to all time highs.

McDonalds (MCD)

In his recent best-selling book Millionaire Teacher, Andrew Hallam likens the run of a stock price from its earnings, like a dog on a leash. He writes how no matter how much a stock price rises, it is always bound by its earnings, and if the share price rises too quickly it will always come back to its average price bound by its earnings – just like a dog on a leash. He demonstrated this principle using the Dividend investor’s favourite, Coca-Cola (KO). This was from an excerpt of Andrew’s book, Conquer the Enemy in the Mirror, which was also published in MoneySense Magazine:

“The stock market is exactly like a dog on a leash. If the stock market races at twice the pace of the business earnings for a few years, then it has to either wait for the business earnings to catch up, or it will get choke-chained back in a hurry. But a rapidly rising stock market can cause people to forget that reality.”  (Andrew Hallam, Millionaire Teacher, pg. 69)

Andrew gives a great example of Coca-Cola from 1988 to 1998 when its earnings increased over 294% for that decade, but the share price soared 996% over the same period. Andrew shows this on figure 4.1 of Millionaire Teacher (pg.69). Not surprisingly, the price of Coca-Cola then declined substantially from a high of $85.50 per share in April 1998, to a low of $40.31 per share in October 2005. It is inevitable that the value of a company (its share price) can only exceed its earnings to a limited amount and period of time – even McDonalds which is now approaching $100 per share.

Why I Bought McDonald’s

Back in March 2011 I purchased McDonalds (MCD) at $75 per share. I was limited with investing capital at the time, and didn’t want to sell my bond ETF holdings, or I would have purchased more. When I purchased MCD in March many considered McDonalds overpriced, and others like myself, saw a great price entry point. This was after a small retreat from its high of $80.34 per share back on December 7th, 2010. At the time McDonalds also had a PE Ratio of around 15, but that PE Ratio has now climbed up to over 19. I’ll cover this metric in Part-2, but to place this in context the Dow 30 has an average PE Ratio of 16, and MCD now has the third highest PE Ratio of the Dow 30 (though comparing CISCO to MCD is like comparing apples and oranges, and I’ll cover that point in Part-2).

Why I’m Selling McDonald’s

When I purchased McDonalds, I made the commitment with my order that if McDonalds reached $100 per share I would sell, and take my profit – a nice 33% profit in a few months. If it went lower, I would do what most dividend investors do, wait and buy more on the dips and dollar cost average my position.  Since McDonalds is not a stock to lose sleep over, and I am comfortable with it as a core holding, I felt this was a winning scenario either way it unfolded.

I have a sell order on MCD at $100 per share, until the end of December. If MCD doesn’t reach that sell point, and the share price declines, then I will top-up on the dips. Regardless, I have my dividend income on MCD at 2.90%, while I’m waiting to see what happens next. For me, it’s a winning scenario either way!

In Part-2, I’ll discuss more about McDonalds. I’ll look at the Price to Earnings relationship in more detail, the PE Ratio, and elaborate further on selling for profit versus a buy-and-hold strategy.

Readers, What’s your take on McDonalds (MCD)? Buying or Selling? Do you like the Angus burger?

26 Responses to “Is McDonalds Overpriced? Part-1”

  1. Chris

    Dec 20. 2011

    I also bought at ~$75 and I’m going to hold. Have you tried the espresso drinks? Just as good as Starbucks IMO. I think there’s still some growth left

    Reply to this comment
    • The Dividend Ninja

      Dec 21. 2011

      Chris I haven’t seen the espresso yet at MCD. I’d love to try it… that goes right after Starbucks doesn’t it? I am sure there is more room for growth, no doubts there. If there is a pull-back you could top up more on the dips ;)

      Cheers!

      Reply to this comment
  2. Six Figure Investor

    Dec 20. 2011

    Ninja,
    The past earnings growth of this company has been about 16% per year recently. If you believe the estimates of 10%/year going forward you could make the case that it is at the high end of valuation, not necessarily overvalued.

    The question becomes if you sell, what will you put the money into? I face a similar issue with some of my investments. Secular/staples stocks have run up recently, higher than I would have predicted.

    What keeps me holding is that the yields that are still pretty good.

    sfi

    Reply to this comment
    • The Dividend Ninja

      Dec 21. 2011

      SFI Thanx for dropping by!

      I love MCD, but I never fall in love with my stocks. I’m just as happy selling a winner as buying an undervalued company (or what is perceived as undervalued). Of course the long-term buy-and-hold strategy is sound, and MCD is one holding to top up on if you hold it.

      I would actually say MCD is likely overvalued, see Michael’s comment below. But that doesn’t mean MCD is not a good stock to own – far from it, a great company! Who knows, it could even go to $200 with a PE of 30?

      If I sell MCD at $100, then I will park the funds into Claymore CLF (1-5 year govt. laddered bond ETF – TSX), and collect the monthly distributions :) It currently pays a coupon rate of 4.5% (YTM is 1.45%).

      btw
      love the info on your webiste, will take some time to read later today :)

      Reply to this comment
  3. Dividend Mantra

    Dec 20. 2011

    Ninja,

    Good stuff! I think we both purchased MCD right around the same time, and at the same price. I purchased a very small lot, as at that time I had less capital on a monthly basis than I do now.

    I wouldn’t say that MCD is overpriced here. I think it’s pretty fairly valued and there are better deals elsewhere. I think the higher multiple is awarded, and deserved, due to the amount of growth the company has experienced and is expected to continue. Although MCD has saturated our market (in terms of stores and our arteries haha!), the global growth still has a lot of fuel behind it. I don’t plan on selling MCD and would gladly buy on a dip back down to $90 or below. If it continues to rise, then I’ll let this winner win. I do not, however, plan on buying any at this price, and especially if it goes over the $100 mark.

    Best wishes!

    Reply to this comment
    • The Dividend Ninja

      Dec 21. 2011

      Mantra Excellent comment! As usual your sound and prudent approach to investing, and your commitment to buying-and-holding quality companies for the long term, is wise indeed ;)

      You and I both bought in at a good time, and I also had to buy a small position of only 20 shares as that was the only cash available in my RRSP.

      You will have some nice opportunities in 2012 to top-up more MCD, I’m certain of it!

      Cheers!

      Reply to this comment
  4. Great post Ninja! Well done on your pick too :) I am looking forward to your next post on MCD.

    I have had MCD in my cross-hair for my RRSP but I have not bought yet and then I looked recently and thought the price was a little sky-high … Good timing on your end :)

    I would like to hold MCD from the perspective of diversification. It has an economic moat on fast food and have proven to be able to compete by offering alternative choices on their menu and I quite like their entry in the coffee market. (I prefer their coffee over Tim Horton)

    It’s a steep price though and I like your comments about its earnings needing to catch up :)

    Reply to this comment
  5. My Own Advisor

    Dec 20. 2011

    Great post, with great details and personal perspective.

    Now for mine :)

    I, like Passive, would like to hold MCD from the perspective of diversification because of that moat. It’s a bit of a sin stock, so I struggle with that, but I already own KO so I guess that’s down the same road. I won’t invest in tobacco companies though!

    Back to MCD, when I look at buying a stock, I look at 52-week highs to help determine the entry point. This guy is flying way too high for entry! Great for capital appreciation. Bad for starting a position.

    That said, I think this is a great company for any long-term dividend investor but if you want to take some profits and use those profits to invest in a lagging index ETF, like VEA, or VWO – I wouldn’t blame you one bit. Or, invest in a down Canadian stock like POW. Sell high and buy low, few people can do this and kudos to you for doing it.

    If you sell, are you selling all of it? I think keeping some MCD is a good call. This guy will keep growing and growing and growing and so will the dividends. If you keep this in your RRSP, you’ve got no withholding taxes either.

    Nice stuff Ninja. I’m looking forward to Part 2!

    Reply to this comment
  6. 101 Centavos

    Dec 21. 2011

    From the perspective of a sin portfolio, MCD sounds like a good pick. I’ve read enough about folks trying to combat their fast-food “addiction” that we could put MCD down as a company selling just-gotta-have bad-for-you products. Think basic necessities like beer, smokes, and sugar.

    Reply to this comment
    • The Dividend Ninja

      Dec 21. 2011

      101 Centavos I have no problem investing in alcohol or fast food companies. But cigarette companies I draw the line (wait a minute those are in my index funds!).

      Reply to this comment
  7. Michael

    Dec 21. 2011

    Just focusing on the 5 year period, 2006 to 2010 (the 2011 financials have not been released yet) The 5 year EPS growth is 61% while the share price has growth 128% in the same period. I would agree with your assessment DN. I love the leash analogy, makes a ton of sense! I hope you revisit this post next year to see how MCD is performing then. I suspect they are headed into a cool down period. Still a great dividend stock, especially if you got it at $75!

    Reply to this comment
    • The Dividend Ninja

      Dec 21. 2011

      Michael Excellent comment and thanx for dropping by! I’m going to attempt to chart the price and EPS for Part-2 so people can visually see the spread between price and earnings ;) MCD was trading at a high of $99.50 this morning. Whew!

      Reply to this comment
  8. Great post ninja! In my opinion MCD is definitely not undervalued, but it isn’t overvalued yet either, it is in a rising trend. Historically it’s low dividend yield is about 2% which would mean the price could go as high as $140. It’s difficult to time these things, I can understand your decision to sell at $100.

    Have you considered holding the shares just to collect the rising dividends?

    I’ve always wondered which strategy is the best:

    Strategy A: buy low, sell high
    Strategy B: buy low, hold forever

    After say 25 years which strategy would provide the highest return?

    Reply to this comment
    • The Dividend Ninja

      Dec 21. 2011

      Kanwal Great comment! I’ve laboured over selling at $100 versus holding forever (dividend mantra style) and topping up on the dips (a dollar cost averaging approach). After all MCD is a phenomenal company, with a massive economic and global moat (as PIE and MOA mention above).

      I want to make a point that I’m not trying to time the market here, $100 is a pre-determined sell point I set when I purchased.

      Your question is equally a good one, and buy and hold forever can pay off big time – most dividend investors have amassed their fortunes this way. Over these last 2 years I’ve been more inclinded to take profits on my winners, with the continually rising markets – but I certainly have a few stocks I have no intention to sell. Great comment Kanwal!

      Cheers

      Reply to this comment
  9. Congratulations on a great 2011 and best wishes for a prosperous 2012! Happy holidays!

    Reply to this comment
  10. Ben

    Dec 30. 2011

    Really interesting aspect about investing into the golden arches… I think it’s a great and solid stock to own.

    Happy Holidays and all the best for 2012 from SmartMoneyGuy.

    Reply to this comment
  11. Dividend Monk

    Jan 01. 2012

    I bought MCD when it was at $92. I was hoping it would dip into the $80′s and allow me to buy more, but it’s over $100 now.

    When I bought it, it was at the upper end of what I was willing to pay. I think it’s a premium brand that deserves a bit of premium price, but at nearly 20x earnings, it’s too high for buying right now, imo.

    I wouldn’t personally classify it was overvalued, or sell it, but it’s not worth buying at this price. It’s a hold, in my view. I’d like to see a correction.

    I’d be willing to buy more if the valuation falls enough to bring the div yield back over 3.00%. I probably wouldn’t sell unless the div yield dropped to 2.25%.

    Reply to this comment

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