A Name for the Value Investor

Cecil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Value investors always hope that great names in the market will come down drastically. McDonald's (NYSE: MCD) is a business that I believe has an extremely wide-moat, and produces very high returns on capital. Over the last decade, few companies have innovated and executed as well as McDonald's, and while I don't believe the next decade will be as fruitful as the last in terms of margin expansion, I believe that at the current valuation there is still plenty of upside for the long-term investor. 

Mickey D's has a more sustainable long-term model than just about any company in this space, and has a low price-to-earnings ratio right now. In a world of short-termism, it's easy to forget that the best investment is measured in years, not quarters, and when you take a look at McDonald's long-term trend, investors are getting a bargain, making McDonald's the better buy today.

McDonald's is trading at around $86 per share and has a market capitalization of about $87 billion. Over the last 12 months McDonald's has generated $5.31 in earnings per diluted share, or $5.445 billion in net income on roughly $27.438 billion in revenue. At current prices McDonald's trades at just over 16 times trailing earnings, and 15 times forward earnings. In a world where the 10-Year Treasury offers a meager 1.66% yield, McDonald's provides the investor with a solid 3.6% and growing dividend yield.

The franchise model is about 4 times as profitable on an operating margin basis, and is the primary factor behind McDonald's increasing returns on invested capital to the high-teens area. Return on equity over the last 12 months is a stratospheric 40%, highlighting the wonderful economics of this business.

The Competition

While Starbucks wouldn't traditionally be considered as direct competition, the McDonald's foray into the coffee market and certain other factors make it a worthy company to look at as an alternative to investing in McDonald's. One of the reasons Starbucks (NASDAQ: SBUX) is worth a look is that it does really well when it comes to two critical investing filters: long-term performance and corporate social responsibility. In its most recent quarter, Starbucks grew its revenue by a very healthy 11% year over year, versus Dunkin Brands 5%, Yum! Brands (NYSE: YUM) 9%, and McDonald's -0.2%. Starbucks' YoY earnings were just a little better than flat in the most recent quarter, at 0.1% growth. That isn't great, but with the world's economic condition the way it is, McDonald's managed only 3.5%; therefore, relatively, it isn't such a bad performance. The company's books are pretty stable too with $2 billion in cash and $550 million in debt. $166 million in cash and $1.9 billion in debt leave Dunkin well below that benchmark. McDonald's and Yum! Brands follow in Dunkin's footsteps in this regard.

Another competitor for McDonald's is Yum! Brands. Yum! is the company behind the popular KFC, Taco Bell, and Pizza Hut restaurant chains. Although the restaurants are well-known in the U.S., the company's real growth prospects have increasingly come from emerging markets like China, where the market isn't nearly as saturated as Yum!'s domestic footprint. The combination of rising commodity costs for food ingredients, a weaker consumer class in some parts of the world, and higher wage costs have hurt Yum!, as well as peers. In its most recent quarter, the company's strong growth continued, with 6% same-store sales gains in both the U.S. and China. 

For Yum! to improve, it needs to get earnings up to where its valuations suggest. High debt levels are also something the company can work on in its quest to get closer to perfection.

The Case for McDonald's

As part of its drive to improve the customer experience, the company is aggressively renovating its restaurants across the globe to a more modern feel. Through September the company has opened 812 restaurants and is on pace to finish the year with over 1,300 new restaurants. Because of the high returns that these new restaurants are generating, the company is able to improve its operating leverage over the long-term. The company continues to increase market share and is making a very large investment in China, which offers huge potential for the company. In 2012, the company is on pace to open 225-250 restaurants and McDonald's is on pace to have 2,000 restaurants operating in the country by the end of 2013. I believe that McDonald's has every opportunity to make China just as big for the company as the United States or Europe is over the long-term, which could clearly have an incredible impact on profits, which makes an incredibly compelling case for the fast food company.

ceciljohn2002 has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend McDonald's and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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