This Company Is A Dividend Gem

By Timothy Green - September 18, 2012 | Tickers: BKW, JACK, MCD, WEN, YUM | 0 Comments

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There is more to the world of dividend stocks than just yield. Sure, a stock yielding 5% seems great, but an equally important aspect of any dividend stock is the dividend growth rate. The key is to find a company offering both an adequate yield and a history of substantial dividend increases. As time passes the income stream generated by such a stock grows, eventually surpassing that of a higher-yielding stock with a lower growth rate. Of course, the sustainability of the dividend is also of paramount importance, so an investor must make sure that the company has more than enough cash flow to fully fund the dividend. One company which meets all of these requirements for a great dividend stock is none other than McDonald's (NYSE: MCD).  

Company Overview 

McDonald's is the behemoth of the fast food industry, operating over 33,000 locations worldwide either directly or through franchisees. Over the past decade McDonald's has undergone a transformation, upgrading restaurants to appear more upscale while diversifying the menu to appeal to a broader set of customers. This strategy has proved extremely successful, as McDonald's has left its main competitors in the dust. Wendy's (NASDAQ: WEN), Burger King (NYSE: BKW), and Jack In The Box (NASDAQ: JACK), which all serve mainly burgers, are each less than 10% the size of McDonald's in terms of revenue. Yum Brands (NYSE: YUM), which owns the Taco Bell, KFC, and Pizza Hut franchises, is less than half the size of McDonald's. Of these competitors only Wendy's and Yum Brands pay a dividend, each yielding less than 2%; McDonald's, on the other hand, yields in excess of 3%.

MCD data by YCharts

McDonald's stock has quadrupled over the past decade, currently trading at $92.13 per share. Burger King just recently IPO'd after being private for a couple of years. Wendy's and Jack in the Box stock both reached a high in 2007 and are both trading for considerably less today. Yum is the only competitor whose stock has performed well, but its paltry dividend compared to McDonald's makes it much less desirable.

During the last decade McDonald's revenue and free cash flow has grown significantly.

* Values in USD Mil

McDonald's has seen dramatic growth over the past decade, and with its enormous size compared to competitors and a world-wide brand McDonald's should remain the top dog in the industry for years to come.

Dividend Growth  

Along with increasing revenue and cash flow McDonald's has consistently been increasing its dividend. Here is the dividend history for the last ten years.

The dividend has increased by more than a factor of 10 over the last ten years, with recent growth rates topping 10%. Anyone who bought McDonald's in 2002 not only saw the stock price appreciate by a factor of 4 but also realized a dramatically increasing income stream. Let's look at the historical payout ratio, which I will calculate using free cash flow instead of earnings, to probe the sustainability of the dividend.

The payout ratio over the past three years has remained steady at around 60%. This is significantly higher than the payout ratios from earlier in the decade, so the extremely high growth rates from pre-2008 are most likely a thing of the past. Because of this, future dividend increases will almost certainly come mainly from increasing profits. 

Valuing The Dividends

In order to estimate the value of McDonald's I will use the Dividend Discount Model. This model assumes that the value of a company is solely the cumulative value of all future dividends discounted back to today. This method is reasonable for an investor focused mainly on dividends. I will assume that the remaining quarterly dividend payment for 2012 will increase by 10% to $0.77. Beyond that, I will assume that the dividend growth rate begins at 10% next year and decays uniformly over the course of 20 years to a perpetual growth rate of 3%. I will use as a discount rate the long-term growth rate of the market as a whole, which is roughly 8%. Doing this allows us to say that if McDonald's stock is undervalued according to this calculation then the dividend stream will provide a greater return than the market as a whole. Using the above parameters I arrive at a fair value estimate of $102 for a share of McDonald's.

Conclusion

McDonald's has seen extraordinary growth over the past decade and has increased its dividend at an astounding rate. Having an advantage in scale compared to its nearest competitors should allow McDonald's to continue to dominate the industry for years to come. The stock is undervalued according to my dividend discount calculation, offering a 3+% yield and a history of strong dividend growth. McDonald's is a dividend gem and would make a fantastic addition to any dividend-focused portfolio. 

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