McDonald's Delicious Dividends

By Andrés Cardenal - May 10, 2012 | Tickers: MCD, SPY, DIA | 0 Comments

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There are different ways to value a company and calculate the returns investors could expect from it in the long term. At the end of the day, achieving a reasonable estimate is not only a matter of the mathematical formulas employed, the key factor to consider is the inputs and suppositions entered into the valuation model. There is an expression used to describe this problem GIGO: garbage in, garbage out.

For this reason, value investors know it's crucial to make moderate or even conservative assumptions when valuing a stock -- if the numbers look good under unadventurous suppositions, then the stock is cheap and there is also room for upside surprises in case things go better than expected.

One interesting measure of value to consider when valuing a company by a safe method is dividends. Dividends are harder to manipulate than earnings, and being a cash payment they provide visibility and income, which is usually very appreciated by conservative investors.

I have compiled in the following tables some financial statistics for McDonald's (NYSE: MCD) about earnings and dividend figures.

Basically, dividends were growing very rapidly when the payout ratio was below 40%. The ratio has now stabilized at around 50% and dividend growth is probably coming down to the same rate as earnings growth in order to keep the payout ratio at those levels. A 50% payout ratio is quite healthy, and it's in line with the dividend policies of other big consumer stocks.

Earnings per share have been expanding consistently between 12% and 15% annually for different time periods, so it sounds like a safe idea to assume a 12% growth rate in dividends for the long term, it's worth noting that McDonald's increased dividends by 15% in the third quarter of last year.

Dividends and their estimated growth rates can be used to estimate the fair value of a company. The problem with that kind of calculation is that it needs a required rate of return for the company under analysis. Those rates of return can be too subjective, and the ending result – fair value of the company – is too sensitive to changes in that required rate of return.

Another alternative is to estimate what rates of returns investors would obtain by investing in the stock at current prices and assuming different growth rates in dividends. The formula would be:

Where r is the rate of return, D1 dividends in the next year and g estimated growth rate in those dividends.

In McDonald's case, with a dividend growth rate of 12%, investors would get a 15% rate of return on their investment over the long term. That's much better than the returns provided by the major indices over the long term, in the line of 10% annually for the S&P 500.  Even if the dividend growth rates were to go down to 10%, McDonald's would still provide a 13% return, which is well above the indices.

It may sound surprising to forecast such an outperformance for a big and stable company like McDonald's, but when looking back in time the company has outperformed the indices by a wide margin. The chart compares McDonald's versus S&P Depository Receipts (NYSEMKT: SPY) and SPDR Dow Jones Industrial Average Trust (NYSEMKT: DIA), which track the S&P 500 and Dow Jones indexes, respectively. The conclusions are quite clear.

McDonald's is much bigger than it was decades ago, so we shouldn't expect the fabulous performance of the past to be repeated in the coming years. An analysis of the company's dividends, however, shows that McDonald's is very well positioned to continue outperforming the indexes in the long term.

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