This Stock Isn't as Expensive as it Appears

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

It's easy to overlook a boring blue-chip stock in favor of a faster growing company. However, many investors make the mistake of assuming that a blue-chip company can't provide superior returns.

This was the mistake that I made with McDonald's (NYSE: MCD). I was more enamored with fast growing concepts like Buffalo Wild Wings, Chipotle (NYSE: CMG), and Panera Bread (NASDAQ: PNRA). I looked at McDonald's expected growth rate of less than 10% as a waste of time, next to companies that might grow their earnings by 19% or 20% in the next few years. However, what I missed was the power of the company's cash flow, and what a difference a good dividend makes.

Would You Like Two Ways to Make Money or Just One?
When you buy a growth stock, unless you are going to write options or make some other bet, you only make money if you sell the shares. When you buy a company that pays a dividend, you may make money when you sell the shares, but you also get paid even if the shares stay flat. If investors use dividend reinvestment, the change in their effective yield can be significant. 

Five years ago, McDonald's stock was selling for about $60 a share. At that time, the dividend yield was about 2.5%. In the last five years, the company has increased the dividend from an annual payout of $1.50 to $3.08. This means if you bought at $60, your effective yield is 5.13%. If you reinvested your dividends over that five year timeframe, your yield would be even higher. If your yield is already over 5% in the last five years, imagine what would happen if you bought 10 or 20 years ago.

The point is, a company with a growing dividend can provide both current income and potential capital gains. A company with no dividend can provide capital gains, or you could end up waiting around and losing money if the stock doesn't go up.

This 'Boring' Business Makes a Lot of Money
In the restaurant industry, companies come and go, and yet McDonald's finds new ways to grow. While the company's current quarter earnings only showed diluted EPS up 4%, this was in a very difficult environment internationally. No matter what is going on, there are two things that McDonald's does better than almost anyone. 

First, McDonald's has a gross margin that is the envy of most of the industry. In the current quarter, the company's gross margin was 39.24%. The only company in its peer group to perform better was Starbucks with a gross margin of 57.35%. However, the fact that Starbucks is known for its upscale coffee offerings, and McDonald's is known for its dollar menu makes this comparison a bit unfair.

Yum Brands (NYSE: YUM) is a better comparison, and that company only managed a 28.75% gross margin in the current quarter. Looking at a few of the faster growing chains, Panera Bread's gross margin is 34.52% and Chipotle's is 24.57%. As you can see, anywhere near its price range, McDonald's gross margin far outstrips the competition.

McDonald's higher gross margin leads to significant free cash flow, and by one measure, no other company does better. In the current quarter, McDonald's generated an estimated $0.14 of free cash flow per dollar of sales. Since McDonald's didn't provide an actual cash flow statement, this is based on the company's net income, plus normal depreciation, minus the company's last quarter capital expenditures. Using the same measure, Yum Brands generated $0.10 of free cash flow per dollar of sales. By comparison, Starbucks generated $0.09 of free cash flow, Panera generated $0.04, and Chipotle generated $0.03.

What About Valuation?
Another reason some investors avoid companies like McDonald's is their valuation. Amateur investors use the PEG ratio, and see that McDonald's PEG is higher than many of their competitors. However, the PEG ratio is incomplete when you are looking at dividend paying companies. What I prefer to use is the PEG+Y ratio. This ratio, which was introduced to me by Peter Lynch's books, adds the company's growth rate to their dividend, and divides by the P/E ratio. Think of this number as an inverted PEG ratio, and remember the higher the better. 

Many would choose Chipotle or Yum Brands over McDonald's based on PEG ratio. However, using PEG+Y, the numbers change a bit. McDonald's PEG+Y is 0.75 from the following calculation (8.89% growth rate + 3.28% yield = 12.17% total return / 16.22 P/E = 0.75). Chipotle's PEG+Y ratio is 0.66 and YUM Brands ratio is 0.68. As you can see, even though Chipotle and Yum Brands are expected to grow faster, they are relatively more expensive.

Starbuck's PEG+Y is 0.80 and Panera Bread's is 0.84, which are both better than McDonald's, but they both rely on faster earnings growth rates to achieve these results. If either chain fails to grow as fast as analysts expect, their ratios would drop.

McDonald's higher yield, better free cash flow generation, and history of raising the dividend makes the choice more difficult than it first appears. The bottom line is, investors need to be careful to not assume a “boring” blue-chip doesn't belong in their portfolio. Sometimes the most boring businesses can be the most exciting investments.


MHenage owns shares of McDonald's. The Motley Fool recommends Chipotle Mexican Grill, McDonald's, and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Panera Bread. 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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